AM FL Y TE Team-Fly®
hel78340_FM.qxd
9/27/01
10:56 AM
Page i
COMMENTS ABOUT ERICH A. HELFERT AND THIS BOOK “Erich Helfert’s book is a bona fide treasury for executives, managers, and entrepreneurs who need to understand financial management. I have used and recommended this great work in both corporate and university programs for more than ten years. Erich Helfert possesses unique abilities to make clear the arcane that frequently enshrouds topics of financial management.” Allen B. Barnes Past Provost IBM Advanced Business Institute (formerly Director of Executive Education, UCLA) “Erich Helfert’s book is a candidate for every consultant-to-management’s bookshelf. The underlying agenda is financial management as it pertains to effective resource allocation decisions. Framed in a dynamic model of the Business System, the beauty of Helfert’s presentation lies in its treatment of subsystems that differentiate between investment, operations and financing decisions, but which are also integrated into the overall managerial fabric.” Stanley Press CMC Book review September 2000 C2M Consulting to Management Journal “Erich Helfert possesses a rare ability to make financial concepts understandable to individuals who lack a financial background. As a result we had Dr. Helfert conduct shareholder value creation classes for all senior managers and create a shareholder value course for all other salaried and hourly employees. The results of these efforts exceeded our high expectations.” L. Pendleton Siegel Chairman and Chief Executive Officer Potlatch Corporation “Erich Helfert has played an instrumental role in teaching HP managers of both financial and non-financial backgrounds in our long-standing Functional Management Program. His excellent financial overviews and simplified models effectively broaden our managers’ understanding and ownership of their fiscal responsibility to HP and our shareholders.” Robert P. Wayman Executive Vice President and Chief Financial Officer Hewlett-Packard Company “Dr. Helfert’s book and his teachings go a long way toward removing the mystery from the financial workings of an enterprise. His approach allows managers from all areas of the business to understand how their decisions impact shareholder value.” Stephen E. Frank President and Chief Operating Officer Southern California Edison “Erich Helfert has contributed to the development of financial skills of TRW managers through his case study preparation and presentations, his book Techniques of Financial Analysis, and his instruction. He continues to be included as a highly rated faculty member in TRW’s management development programs.” Peter S. Hellman Past President and Chief Operating Officer TRW Inc.
This page intentionally left blank.
hel78340_FM.qxd
9/27/01
10:56 AM
Page iii
FINANCIAL ANALYSIS: TOOLS AND TECHNIQUES A Guide for Managers
ERICH A. HELFERT, D.B.A.
McGraw-Hill New York Chicago San Francisco Lisbon London Madrid Mexico City Milan New Delhi San Juan Seoul Singapore Sydney Toronto
abc
McGraw-Hill
Copyright © 2001 by The McGraw-Hill Companies. All rights reserved. Manufactured in the United States of America. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher. 0-07-139541-5 The material in this eBook also appears in the print version of this title: 0-07-137834-0. All trademarks are trademarks of their respective owners. Rather than put a trademark symbol after every occurrence of a trademarked name, we use names in an editorial fashion only, and to the benefit of the trademark owner, with no intention of infringement of the trademark. Where such designations appear in this book, they have been printed with initial caps. McGraw-Hill eBooks are available at special quantity discounts to use as premiums and sales promotions, or for use in corporate training programs. For more information, please contact George Hoare, Special Sales, at
[email protected] or (212) 904-4069.
TERMS OF USE This is a copyrighted work and The McGraw-Hill Companies, Inc. (“McGraw-Hill”) and its licensors reserve all rights in and to the work. Use of this work is subject to these terms. Except as permitted under the Copyright Act of 1976 and the right to store and retrieve one copy of the work, you may not decompile, disassemble, reverse engineer, reproduce, modify, create derivative works based upon, transmit, distribute, disseminate, sell, publish or sublicense the work or any part of it without McGrawHill’s prior consent. You may use the work for your own noncommercial and personal use; any other use of the work is strictly prohibited. Your right to use the work may be terminated if you fail to comply with these terms. THE WORK IS PROVIDED “AS IS”. McGRAW-HILL AND ITS LICENSORS MAKE NO GUARANTEES OR WARRANTIES AS TO THE ACCURACY, ADEQUACY OR COMPLETENESS OF OR RESULTS TO BE OBTAINED FROM USING THE WORK, INCLUDING ANY INFORMATION THAT CAN BE ACCESSED THROUGH THE WORK VIA HYPERLINK OR OTHERWISE, AND EXPRESSLY DISCLAIM ANY WARRANTY, EXPRESS OR IMPLIED, INCLUDING BUT NOT LIMITED TO IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE. McGraw-Hill and its licensors do not warrant or guarantee that the functions contained in the work will meet your requirements or that its operation will be uninterrupted or error free. Neither McGraw-Hill nor its licensors shall be liable to you or anyone else for any inaccuracy, error or omission, regardless of cause, in the work or for any damages resulting therefrom. McGraw-Hill has no responsibility for the content of any information accessed through the work. Under no circumstances shall McGraw-Hill and/or its licensors be liable for any indirect, incidental, special, punitive, consequential or similar damages that result from the use of or inability to use the work, even if any of them has been advised of the possibility of such damages. This limitation of liability shall apply to any claim or cause whatsoever whether such claim or cause arises in contract, tort or otherwise. DOI: 10.1036/0071395415
hel78340_FM.qxd
9/27/01
10:56 AM
Page v
To Anne
This page intentionally left blank.
hel78340_FM.qxd
9/27/01
10:56 AM
Page vii
ABOUT THE AUTHOR
Erich A. Helfert is an internationally recognized management consultant in corporate finance, strategic planning, and executive education in financial/economic decision making and shareholder value creation. He gained his professional experience from a combination of distinguished business and academic careers. Dr. Helfert was vice president, corporate planning, at Crown Zellerbach Corporation, a major integrated paper and forest products company. Prior to his 20-year corporate career, he served on the faculty of the Harvard Graduate School of Business for eight years, teaching finance and managerial economics in the MBA program, and consulting in management development and strategy with major companies. A native of the Sudetenland, formerly Austria, he received his BS from the University of Nevada and earned both an MBA (with high distinction) and a DBA (as a Ford Foundation Fellow) at the Harvard Business School. Dr. Helfert writes and lectures extensively in his field, and his books and articles have been published in the United States and abroad. His first literary work, Valley of the Shadow, a factual historical novel about his experiences in central Europe at the end of World War II, was published recently. Dr. Helfert is cofounder, chairman and CEO of Modernsoft, Inc., San Mateo, California, developers of Financial Genome, an advanced knowledge-based financial analysis and business modeling software, which is complementary to Financial Analysis: Tools and Techniques. vii
Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
This page intentionally left blank.
hel78340_FM.qxd
9/27/01
10:56 AM
Page ix
CONTENTS
Preface
xvii
Introduction xxi Chapter 1
The Challenge of Financial/Economic Decision-making 1 Lessons for the Millennium 2 The New Economy 2 Some Key Questions 3 The Basics Never Change 6 The Economic Manager 7 Understanding Business Economics 8 Appropriate Economic Tools 9 The Practice of Financial/Economic Analysis 10 Day to Day Decisions and Operational Planning 10 Supporting Strategy Development 11 Performance Assessment and Incentives 12 Valuation and Investor Communications 14 The Value Creating Company 15 Relevant Decision Information 15 Economic Incentives 17 Total Systems Management 18 Chapter 2
A Systems Context for Financial Management 21 A Dynamic Perspective of Business 22 Decision Context 22 The Business System 26 Investment Decisions 29 Operating Decisions 31 Financing Decisions 33 Interrelationship of Strategy and Value Creation 36 ix
Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
hel78340_FM.qxd
9/27/01
10:56 AM
Page x
x
Contents
The Nature of Financial Statements 37 The Balance Sheet 38 The Income Statement 40 The Cash Flow Statement 42 The Statement of Changes in Shareholders’ (Owners’) Equity 46 The Context of Financial Analysis 50 Key Issues 55 Analytical Support 57 Chapter 3
AM FL Y
Managing Operating Funds 59
TE
Funds Flow Cycles 61 The Funds Cycle for Manufacturing 64 The Funds Cycle for Sales 67 The Funds Cycle for Services 69 Variability of Funds Flows 70 Growth/Decline Variations 70 Seasonal Variations 74 Cyclical Variations 75 Generalized Funds Flow Relationships 77 Interpreting Funds Flow Data 78 Funds Management and Shareholder Value 89 Cash Management 89 Working Capital Management 90 Investment Management 91 Key Issues 91 Analytical Support 93 Chapter 4
Assessment of Business Performance 95 Ratio Analysis and Performance 95 Management’s Point of View 97 Operational Analysis 98 Resource Management 107 Profitability 112 Owners’ Point of View 115 Investment Return 116
Team-Fly®
hel78340_FM.qxd
9/27/01
10:56 AM
Page xi
Contents
Disposition of Earnings 121 Market Indicators 123 Lenders’ Point of View 126 Liquidity 126 Financial Leverage 128 Debt Service 130 Ratios as a System 132 Elements of Return on Assets 133 Elements of Return on Equity 134 Integration of Financial Performance Analysis 137 Some Special Issues 139 Inventory Costing 140 Depreciation Methods 141 The Impact of Inflation 144 Key Issues 145 Analytical Support 147 Chapter 5
Projection of Financial Requirements 161 Pro Forma Financial Statements 163 Pro Forma Income Statement 164 Pro Forma Balance Sheet 167 Pro Forma Cash Flow Statement 171 Cash Budgets 174 Operating Budgets 178 Sales Budget 179 Production Budget 181 Interrelationship of Financial Projections 181 Financial Modeling 184 Sensitivity Analysis 186 Key Issues 187 Analytical Support 189 Chapter 6
Dynamics and Growth of the Business System 191 Leverage 192 Operating Leverage 193
xi
hel78340_FM.qxd
9/27/01
10:56 AM
Page xii
xii
Target Profit Analysis 202 Financial Leverage 203 Financial Growth Plans 209 Basic Financial Growth Model 210 Sustainable Growth and the Sustainable Growth Equation 214 Integrated Financial Plan 217 Key Issues 220 Analytical Support 222 Chapter 7
Cash Flows and the Time Value of Money 223 The Time Value of Money 224 Discounting, Compounding, and Equivalence 224 Components of Analysis 231 Net Investment 232 Net Operating Cash Inflows 232 Economic Life 233 Terminal (Residual) Value 233 Methods of Analysis 234 Simple Measures 234 Economic Investment Measures 237 Net Present Value 237 Present Value Payback 242 Profitability Index (BCR) 244 Internal Rate of Return (IRR, Yield) 245 Annualized Net Present Value 247 Applying Time-Adjusted Measures 250 Key Issues 250 Analytical Support 252 Chapter 8
Analysis of Investment Decisions 255 Strategic Perspective 256 Decisional Framework 259 Problem Definition 260 Nature of the Investment 261 Future Costs and Benefits 262
Contents
hel78340_FM.qxd
9/27/01
10:56 AM
Page xiii
Contents
Incremental Cash Flows 263 Relevant Accounting Data 264 Sunk Costs 265 Refinements of Investment Analysis 266 A Machine Replacement 266 Net Investment Refined 267 Operating Cash Inflows Refined 268 Unequal Economic Lives 271 Capital Additions and Recoveries 272 Analytical Framework 272 A Business Expansion 275 Mutually Exclusive Alternatives 277 Maintain versus Replace 277 Full-Fledged versus Economy Solution 279 Comparing Different Scenarios 280 Dealing with Risk and Changing Circumstances 282 Specifying Risk 283 Ranges of Estimates 284 Business Investments as Options 285 Probabilistic Simulation 287 Risk-Adjusted Return Standards 288 When to Use Investment Measures 289 Some Further Considerations 291 Leasing—A Financing Choice 291 Accelerated Depreciation 292 Inflation and Investment Analysis 292 Accuracy 293 Key Issues 293 Analytical Support 295 Chapter 9
Cost of Capital and Business Decisions 297 Decisional Context 298 Investment Decisions 298 Operating Decisions 299 Financing Decisions 300 Cost of Operating Funds 300 Cost of Long-term Debt 304
xiii
hel78340_FM.qxd
9/27/01
10:56 AM
Page xiv
xiv
Cost of Shareholders’ Equity 305 Preferred Stock 305 Common Equity 306 Weighted Cost of Capital 312 Cost Choices 312 Weighting the Proportions 313 Calculating the Weighted Cost of Capital 315 Cost of Capital and Return Standards 317 Cost of Capital as a Cutoff Rate 318 Risk Categories 319 Cost of Capital in Multibusiness Companies 321 Multiple Rate Analysis 322 Key Issues 322 Analytical Support 324 Chapter 10
Analysis of Financing Choices 325 Framework for Analysis 326 Cost of Incremental Funds 326 Risk Exposure 327 Flexibility 328 Timing 328 Control 329 The Choice 330 Techniques of Calculation 330 Current Performance 331 Long-Term Debt in the Capital Structure 332 Preferred Stock in the Capital Structure 335 Common Stock in the Capital Structure 336 Range of Earnings Chart 339 The Optimal Capital Structure 345 Some Special Forms of Financing 347 Leasing 347 Convertible Securities 350 Stock Rights 351 Warrants 352 Key Issues 352 Analytical Support 354
Contents
hel78340_FM.qxd
9/27/01
10:56 AM
Page xv
Contents
Chapter 11
Valuation and Business Performance 357 Definitions of Value 358 Economic Value 358 Market Value 359 Book Value 360 Liquidation Value 360 Breakup Value 361 Reproduction Value 361 Collateral Value 361 Assessed Value 362 Appraised Value 362 Going Concern Value 362 Shareholder Value 363 Value to the Investor 363 Bond Values 363 Preferred Stock Values 368 Common Stock Values 372 Specialized Valuation Issues 378 Rights and Warrants 378 Options 379 Business Valuation 380 Valuing the Equity 381 Valuing the Total Company 382 Using Shortcuts in Valuing an Ongoing Business 387 Key Issues 388 Analytical Support 389
Chapter 12
Managing for Shareholder Value 391 Shareholder Value Creation in Perspective 392 Evolution of Value-Based Methodologies 396 A Review of Key Measures 398 Economic Profit and CFROI 402 Creating Value in Restructuring and Combinations 411 Restructuring and Value 411
xv
hel78340_FM.qxd
9/27/01
10:56 AM
Page xvi
xvi
Contents
Combinations and Synergy 414 Combinations and Share Values 415 Integration of Value Analysis 417 Perspectives 418 Expectations 419 Time Period 419 Cash Flow Pattern 419 Ongoing Values 420 Comparables 420 Negotiations 421 Key Issues 421 Analytical Support 423 APPENDIX I
Financial Analysis Using Financial Genome
425
APPENDIX II
Glossary of Key Terms and Concepts 433 APPENDIX III
Financial Information and On-Line Sources 449 APPENDIX IV
Basic Inflation Concepts 463 APPENDIX V
Some Issues in Multinational Financial Analysis 469 INDEX 477
hel78340_FM.qxd
9/27/01
10:56 AM
Page xvii
PREFACE
This volume is an adaptation for the professional market of the most recent 10th (“millennium”) edition of Dr. Helfert’s best-selling Techniques of Financial Analysis, which, with more than half a million copies in print over the past 38 years, has given the student, analyst, and business executive a concise, practical, usable, and up-to-date overview of key financial/economic analysis tools. The presentation format has always been carefully designed to help the reader understand the linkage between management decisions and their impact on the financial performance and the economic value of a business. This book helps the reader to interpret financial reports, develop basic financial projections, evaluate business investment decisions, assess the implications of financing choices, derive the value of a business or a security, and understand the role of analysis in achieving the goal of shareholder value creation. Every technique and measure is described and demonstrated in the context of important underlying financial and economic concepts, but without delving into theoretical abstraction.
A Unique Systems Approach to Financial Management The concept that any business is essentially an integrated system of cash flows driven by management decisions provides the book’s foundation. All analytical tools and related financial/economic concepts are discussed within this systems context, which reflects the three basic types of decisions made continuously by the management of any ongoing business: investment, operating, and financing. The materials are also structured around the viewpoints of the major parties interested in the analysis and performance of a business: managers, owners, and creditors. The book begins by providing a perspective on the recent speculative excesses in the new economy’s “dotcom” revolution, with the argument that basic economics and financial analysis have never changed, but only were ignored at times. Next, the key concept of the business system and all of its relationships to financial analysis and statements is presented in detail, from which the discussion proceeds to explain the various techniques and concepts in a logical flow. Closure is provided by returning to the systems concept in the final chapters on valuation and managing for shareholder value. Within this structure, however, practicality always remains paramount. Any issues and concepts going beyond what is essential are left to the more specialized textbooks and articles identified in the references. The systems approach is also reflected in the commercially available Financial Genome business analysis and planning software and its accompanying interactive templates.
xvii
Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
hel78340_FM.qxd
9/27/01
10:56 AM
xviii
Page xviii
Preface
The Audience Ever since the first edition appeared in 1963, the book has consistently maintained a unique appeal both for students (graduate and undergraduate) and practitioners because of its clarity and commonsense presentation. Straddling the educational and professional markets, the book requires little if any background in finance and accounting and provides an accessible, self-contained overview of the essential financial management concepts and tools. Countless students have found the book an understandable and useful guide for their studies and kept the book for ready reference in their careers, while large numbers of professionals—whether financial practitioners or nonfinancial managers—recognized the practicality and applicability of the book’s approach to their needs and decision-making. Originally an outgrowth of the compact technical briefing materials used in the MBA program at the Harvard Business School, which supplement practical case study discussion with essential background, the book has been regularly updated and modified approximately every four years. The tenth “millennium” edition reflects not only the latest practice in the use of the various financial techniques, but also the experience gained over nine editions from the widespread use the book has enjoyed in university finance courses, both graduate and undergraduate, and from hundreds of executive development seminars and in-company programs in the United States, Canada, Latin America, and overseas, including those conducted by the author in numerous Fortune 100 client companies. Frequently translated into nine foreign languages over the years, the book has transcended the confines of American business practice on which it is built, because the way in which the analytical methods are described makes them almost universally applicable.
What’s New in this Book The 10th edition of Techniques of Financial Analysis, on which this volume is based, has been refined and updated while preserving the logical, integrated flow of the materials. After setting the stage in Chapter 1, the coverage begins with an overview of the “business system” and the key financial analysis tools, all the way to the development of business valuation and the newly developed materials on managing for shareholder value. The discussion of the analysis of business investments and business valuation have been expanded into two chapters each, to provide additional insights, practical examples, and greater linkage to shareholder value creation. The various graphics supporting the text, several of them new additions, were tested for their effectiveness in numerous executive development programs over the past 12 years. Also, where appropriate, specific references to spreadsheet analysis have been included and examples are presented in this readily accessible format to ease the mechanical aspects of analysis. An entirely new feature is the optional availability of the advanced, knowledge-based financial analysis software package, Financial Genome, created by
hel78340_FM.qxd
9/27/01
10:56 AM
Preface
Page xix
xix
Modernsoft, Inc. This professional application enables the user to develop financial statements, the whole range of key financial measures, and integrated financial projections and plans, as well as ad hoc financial analyses. The patented knowledge-based technology enables the user to readily perform these tasks from spreadsheet data or data bases with assured internal consistency, without having to worry about cell locations and formulas. Knowledge of financial terms, relationships, and statement structures is built in, but can be accessed and displayed at will for enhanced understanding. The software is also accompanied by a series of interactive templates and displays relating to many of the key exhibits of this book, especially the core diagram of the business system. The templates are designed to enhance the learning experience by graphically illustrating the impact of changes in assumptions and conditions. Many templates are also designed for general use, such as break-even and present value analysis. Financial Genome is described in detail in Appendix I. Interested readers can download the software for trial, as well as the “TFA Templates,” from Modernsoft, Inc’s web site: www.modernsoft.com. As before, chapters 2 through 6 of the book form an integrated set, built around the conceptual overview of the business system, its decisional context, and its relationship to financial statements and analytical tools as presented in Chapter 2. The coverage of analytical methods begins in Chapter 3 with funds flow analysis, moves on to financial performance analysis, covers financial projections, and culminates in a discussion of the financial dynamics useful in modeling financial conditions and growth capabilities. Chapters 7 through 11 deal with more specialized topics such as business investment analysis, the cost of capital, financing choices, and valuation of securities and businesses, while the final Chapter 12 returns to the systems context in an expanded discussion of the conceptual and analytical aspects of managing for shareholder value. The informational Appendix III was updated to include key online references. The process of revision and current adaptation has not, however, affected the book’s primary focus on the doable and practical—in effect an “executive briefing” concept—and on building the reader’s basic ability to grasp financial relationships and issues. As before, the book presupposes only that the user has some familiarity with basic accounting concepts.
Acknowledgments I would again like to express my appreciation to my former colleagues at the Harvard Business School for the opportunity to develop the original concept of the book. My thanks also go to my business associates and to my colleagues at universities and in executive development programs here and abroad, too numerous to mention individually, for their continued extensive use of the book and for the many expressions of interest and constructive suggestions that have supported the book’s evolution.
hel78340_FM.qxd
9/27/01
10:56 AM
Page xx
xx
Preface
TE
AM FL Y
My special thanks go to my colleagues at Modernsoft, Inc., Edgar P. Canty, Dr. William J. Clancey, John W. Wu, and Lee Hecht for their enthusiasm and expertise in adapting the major concepts of the book and its approach in our development of the Financial Genome software and its accompanying educational templates. Their insights and suggestions were most valuable during the recent revision of this book, and their unwavering dedication to creating this unique professional financial analysis and planning software has been exemplary. I would also like to state my sincere appreciation to the McGraw-Hill publishing team who made this edition a reality; Jeffrey Krames, Publisher, and Stephen Isaacs, sponsoring editor, have both consistently and generously guided the book through its various stages. Finally, I continue to be most gratified by the positive responses from so many individual users, past and current, who have found the book helpful in their studies and an ongoing supportive resource in their professions.
Team-Fly®
Erich A. Helfert
hel78340_FM.qxd
9/27/01
10:56 AM
Page xxi
INTRODUCTION
When an analyst, business executive, or student is dealing with a financial issue, or wishes to understand the financial implications and economic trade-offs involved in decisions about business investment, operations, or financing, a wide variety of analytical techniques—and sometimes rules of thumb—is available to generate quantitative answers. Selecting the appropriate tools from these choices is clearly an important part of the analytical task. Yet, experience has shown again and again that first developing a proper perspective for the problem or issue is just as important as the choice of the tools themselves. Therefore, this book not only presents the key financial tools generally used, but also explains the broader context of how and where they’re applied to obtain meaningful answers. To this end, the second chapter provides an integrated conceptual backdrop both for the financial/economic dimensions of systematic business management and for understanding the nature of financial statements, data, and processes underlying financial analysis techniques. All subjects are viewed in the context of creating shareholder value—a fundamental concept that is revisited in the final chapter on managing for shareholder value. While the tools and techniques covered in this book are discussed and demonstrated in detail, the user must not be tempted to view them as ends in themselves. It’s simply not enough to master the techniques alone! Financial/ economic analysis is both an analytical and a judgmental process which helps answer questions that have been carefully framed in a managerial context. The process is at its best when the analyst’s efforts are focused primarily on structuring the issue and its context, and only secondarily on data manipulation. We can’t stress enough that the basic purpose of financial analysis is to help those responsible for results to make sound business decisions within a relevant cash flow framework. Apart from providing specific numerical answers, “solutions” to financial problems and issues depend significantly on the points of view of the various parties involved, on the relative importance of the issue, and on the nature and reliability of the information available. In each situation, the objective of the analysis must be clearly understood before pencil is put to paper or computer keys are touched—otherwise, the process becomes wasteful “number crunching,” even if the workload itself is eased by analytical software. Management has been defined as “the art of asking significant questions.” The same applies to financial analysis, which should be targeted toward finding meaningful answers to these significant questions—whether or not the results are fully quantifiable. In fact, the qualitative judgments involved in finding answers to financial/economic issues can often count just as heavily as the quantitative xxi
Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
hel78340_FM.qxd
xxii
9/27/01
10:56 AM
Page xxii
Introduction
results, and no analytical task is complete until these aspects have been carefully spelled out and weighed. The degree of precision and refinement to which any financial analysis is carried also depends on the specific situation. Given the uncertain nature of many of the estimates used in calculations, it’s often preferable to develop ranges of potential outcomes rather than precise answers. At the same time, a lot of effort can be wasted in further refining answers that clearly suggest the choice of particular alternatives—there’s no need to belabor the obvious! Moreover, common sense dictates that most of the analytical effort should be directed at areas where the likely payoff from additional analysis is largest—to match the amount of energy expended with the significance of the results. The following points are a suggested checklist for review and consideration before any financial analysis task is begun. This list should be helpful to the person actually doing the work as well as to the manager who may have assigned the question or project to an associate: 1. What’s the exact nature and scope of the issue to be analyzed? Is the issue and its relative importance in the overall business context truly understood, and have its attributes been clearly spelled out, including all the relevant alternatives that should be considered? 2. Which specific variables, relationships, and trends are likely to be helpful in analyzing the issue? What’s the order of their importance, and in what sequence should they be addressed? 3. Are there possible ways to obtain a quick “ballpark” estimate of the likely result to help decide (a) what the critical data and steps might be, and (b) how much effort should be spent on refining these? 4. How precise an answer is necessary in relation to the importance of the issue itself? Would additional refinement be worth the effort? 5. How reliable are the available data, and how is this uncertainty likely to affect the range of results? What confirmation might be possible, and at what degree and cost of effort? 6. Are the input data to be used expressed in cash flow terms—essential for economic analysis—or are they to be applied within an accounting framework to test only the financial implications of a decision? 7. What limitations are inherent in the tools to be applied, and how will these likely affect the range of results obtained? Are the tools chosen truly appropriate to solving the issue? 8. How important are qualitative judgments in the context of the issue, and what’s the ranking of their significance? Which analytical steps might in fact be made unnecessary by such considerations? Only after having thought through these questions should specific analytical work on any issue proceed. The amount of care and effort expended on taking this critical first step at the beginning of the task will pay off in much more focused and meaningful work and results. In effect, we’re talking about using a
hel78340_FM.qxd
9/27/01
Introduction
10:56 AM
Page xxiii
xxiii
rational approach to problem solving in financial/economic analysis. In the end, this is what effective support of decision making involving a company’s investments, operations, and financing is all about, because shareholder value creation is the logical result of sound business decisions carefully analyzed and successfully implemented.
This page intentionally left blank.
hel78340_ch01.qxd
9/27/01
10:57 AM
Page 1
CHAPTER 1
THE CHALLENGE OF FINANCIAL/ECONOMIC DECISION-MAKING
A
t the time the tenth edition of this book appeared in August 1999, the business world was caught up in a still-growing state of euphoria over the high technology sector and especially the “dot.com” phenomenon, which promised to revolutionize the way business was done, whether business-to-business or businessto-consumer. There was also the impression, actively promoted by many commentators, pundits and financial professionals, that a different era of analytical practice had arrived. It was argued that many of the “old” ways of judging performance and business prospects would no longer be valid, as market valuations of scores of new or emerging businesses skyrocketed. However, when the market bubble contracted sharply, beginning in the Spring of 2000 and into the first year of the new millennium, 2001, there was a great deal of soul searching among financial professionals and investors alike, all trying to explain the sharp reversal and to speculate on how it was possible that so many judgments and expectations were not founded in reality. As a way of introducing the range of analytical concepts and tools contained in this book, we’ll attempt to characterize some of the key attributes of the “new economy” phenomenon and draw conclusions about the implications for financial analysis. In fact, we’ll argue that the “basics” of financial/economic analysis and thinking have never changed. Many of the excesses of the period might have been prevented if even the most elementary economic principles had been followed. We’ll put into perspective the constructive role of what we call the economic manager, a quintessential requirement for sustainable success in businesses large and small. This will also be an opportunity to comment briefly on the practice of financial/economic analysis in operating and assessing a business. Finally, we’ll characterize the key attributes of the value-creating company, the successful enterprise with a robust business model and a sustainable strategic advantage, which fulfills and even exceeds expectations of the investing community. 1
Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
hel78340_ch01.qxd
9/27/01
10:57 AM
Page 2
2
Financial Analysis: Tools and Techniques
For many years the purpose and contribution of this book have been to help make financial/economic analysis a practical, understandable and usable process for managers and analysts, and we argue with conviction that applying these concepts to both established and emerging businesses has rarely been more important than now. As we enter the new millennium, continuation of our strong economic performance in the fast-moving business environment will depend on how well internal decision-making processes support and extend the new technologies and productivity improvements—which, after all, have helped create a decade of record economic expansion. We believe that the decision criteria for these processes should be, and will remain, based on sound economic principles, on the use of cash flow reasoning, and on well-defined trade-offs involved in decisions large and small. In other words, we are talking about applying solid economic management.
Lessons for the Millennium As we enter the new millennium, two sets of issues about financial/economic analysis principles and practice offer themselves for discussion as an introduction to this book. The first is the concept of the so-called new economy, and the second is the applicability and relevance of time-tested methodologies and tools in the years ahead.
The New Economy Much has been written and said about the impact of new technologies, of the information revolution, and of the Internet on our economy, not only in the United States, but worldwide. There is no question that the changes in information technology and communications capability have drastically altered both actual and potential ways of doing business. For example, instant access to inventory status at both the customer and manufacturer/supplier levels, and creative linkages through order processing and outsourcing have not only reduced funds tied up in inventories, but have also aligned these companies much more closely with actual demand patterns. The ability to customize products and services has been greatly enhanced, while lead times have shrunk in the supply chain to unheard of low levels. Information technology has been the key to achieving much more effective processes throughout the business world, and once they are properly selected and managed, the processes of data access, storage, application and exchange become much easier. The Internet has become the facilitator for instant sharing of information, and for linking entities with common interests and needs. Beyond that, the Internet promises to become a preferred processing medium for countless services, including accounting, data storage, analytical software, investment analysis, and others, offering instant access from any point in the world. Not only can high technology companies take advantage of these
hel78340_ch01.qxd
9/27/01
10:57 AM
Page 3
CHAPTER 1 The Challenge of Financial/Economic Decision-Making
3
capabilities, but the potential for productivity enhancement extends to even the most basic of industries and services. The examples cited above, as well as new applications not yet developed, can have a significant impact on both operational and strategic conditions in most industries and services. The business models of existing companies have to be adjusted to reflect the capabilities of these developments, to the extent that they apply. Likewise, companies directly engaged in pursuing such emerging and fastpaced opportunities must develop business models that are likely to succeed, even though they find themselves on the leading edge of new developments that are not yet fully understood. Thus the new economy represents both an opportunity and a challenge to business management. What are the implications of these trends for business financial analysis and economic decision-making? Clearly, the pace of business activity and the speed with which opportunities emerge has accelerated greatly, resulting in the need for quicker analysis and decision-making. This means, among other things, designing information gathering and interpretation processes to ensure that appropriate decision-making data are available when needed. It also means that internal decision practices need to be rationally attuned to these shorter time frames. All these issues can be addressed in methodical ways.
Some Key Questions However, several business concepts have emerged in the recent past that give ample reason to pause and consider whether they represent a dose of wishful thinking. These concepts largely apply to the new and emerging businesses of the new economy, but also have cast a shadow over more established companies. We’ll look at the most important ones briefly: • Successive advances in innovation guarantee success. • High volume position is the key to competitive advantage. • Profitability is an old-fashioned concept.
Innovation. The idea that successive waves of innovation are the main driver of long-term performance in a new or emerging business—or an existing one, of course—appears to be sound when viewed in the abstract. Clearly, innovations in technology, processes, and methodology have occurred, sometimes dramatically, in the U.S. and world economies. Whole new businesses emerged over the past two centuries as advances in manufacturing, transportation, services and communication came in sometimes rapid, successive cycles, speeding up exponentially in the past several decades. But the important lesson from economic history is that innovation alone does not guarantee success to the individual enterprise, whether pioneering or merely riding along with the changing opportunities.
hel78340_ch01.qxd
4
9/27/01
10:57 AM
Page 4
Financial Analysis: Tools and Techniques
It is here that the interpretation of the new economy and its innovative aspects began to conflict with basic economic reality in the past several years. As high-technology and “dot.com” enterprises attempted to seize the potential of innovative advances, basic notions of achieving positive cash flow and profits were cast aside. Instead, the argument was: “As long as we keep innovating and are doing it faster than others, we’ll have positioned ourselves to warrant the confidence of our investors.” It was this argument that contributed to the phenomenon of initial public offering prices soaring to unprecedented heights, giving new and untried enterprises market valuations that rivaled those of long-established, successful Fortune 100 corporations. The magic lure of innovation became a substitute for economic performance, and rampant speculation rather than thoughtful analysis drove venture capitalists, investment bankers, analysts, and individual investors to participate in the ride to quick riches. Forgotten was the fact that where a great many innovators try, only a very few succeed, and they succeed only because they achieve acceptable financial results within a time span over which investors are willing to commit themselves. Ignored was the fact that results depend on the ability to deliver products and services which customers are actually willing to buy at adequate prices. One only has to think of the number of automobile companies that were started at the beginning of the automotive age, and how many survived, despite technical innovations made by many firms that no longer exist. The reason the innovating company succeeds is because it is built on sound, sustainable strategies, effective management, and economic decision-making, enabling it to seize and exploit innovative opportunities better than its rivals. If successive innovations come along, the successful company will repeat these principles. Thus it is not innovation alone, but the consistent and difficult application of sound strategic and economic management that brings about eventual success. And the underpinnings of such successful strategic and economic management are sound financial/economic analysis and its interpretation—the very principles and tools we’ll discuss in this book.
Volume position. The second concept we wish to highlight also appears sound when viewed in principle, namely, that obtaining a commanding volume position in the market as early as possible is a critical ingredient of successful strategies. This can lead to lower costs, more effective marketing, logistics, synergies and lasting competitive advantage. General Electric, one of the most successful longrun value builders for decades, preached and practiced Jack Welch’s mantra of being No. 1 or No. 2 in any of the businesses in which it chose to engage and continue. When it came to the new economy, however, the same principle was often applied without much thought being given to one critical economic requirement: the trade-off between the outlays required to establish position, and the economic benefits to be derived over time from this investment. In the “dot.com” sector of the economy, the principle of large scale and volume was interpreted as, for example, getting the most “eyeballs” to view one’s web site, or building up the largest customer base possible, using give-away prices for products and services.
hel78340_ch01.qxd
9/27/01
10:57 AM
Page 5
CHAPTER 1 The Challenge of Financial/Economic Decision-Making
5
As “clicks competed with bricks,” little attention was paid to the size of the requisite outlays on advertising, promotion, and particularly the often massive investment in fulfillment infra-structure, with its related operating costs. In extreme cases, the spending of hundreds of millions of dollars of shareholder capital or borrowed funds was shrugged off as “necessary” to build scale, to get ahead of several other competitors and reach the dominant position. There are many examples of such new business models, established in the hope of reaching commanding volume positions, such as amazon.com, webvan.com, Etoys.com, and others; some of these have by now expired, especially those startups trying to serve consumer markets in new ways. Expectations about positive operating results kept being postponed year after year in many of these situations—with investment soaring and operational contributions to the bottom line remaining negative. Cash flows consistently remained a one-way street. At some point of reckoning such companies faced bitter choices: trying to raise additional funds under prohibitive conditions, selling out, or folding up altogether. The expected positive trade-off between investment and expectations had not materialized, and shareholders were penalized by collapsing share prices. We believe that one of the main reasons the trade-off failed was the lack of importance, or even outright disregard, with which management viewed the use of hardheaded financial/economic analysis. Successful companies generally subject their new initiatives to various forms of “no nonsense” testing, carefully weighing ranges of potential investment against ranges of potential outcomes. Even elementary analysis of this kind, when applied to a number of the new “dot.com” business models, suggests that economically recovering the kinds of investments necessary requires growth rates, market positions and operating results that far exceed any set of reasonable estimates an objective observer might make about the potential scale and profitability of the business sector in question. The counter arguments made by some suggested that because these market opportunities and business models were so new, estimates were essentially bluesky guesses, and one could not afford to lose time in becoming Number One. As we’ll discuss in the later portions of this book, however, uncertainty about the future is a common theme in just about all business propositions, and the issue is one of carefully scoping the likely dimensions, and assessing the risks involved as the analysis proceeds. In the case of the new economy business models, the rush to gain position and to be the first to benefit from it, did overshadow economic principle in the eyes of analysts, venture capitalists, and investors. The hurry to position oneself for a huge run-up in share prices became a speculative race where caution was thrown to the wind.
Profit is old-fashioned Related to the first two issues we discussed is the notion that in the new economy, the old fashioned principle of achieving sustained profitability is obsolete. Concepts such as “top line growth,” a metaphor for rapid sales increases, and other physical measures having to do mainly with positioning
hel78340_ch01.qxd
9/27/01
10:57 AM
Page 6
6
Financial Analysis: Tools and Techniques
TE
AM FL Y
are becoming increasingly popular. There is no denying that these measures have a place in the arsenal of analytical tools, as they help to interpret the trends affecting business performance. But they are by no means a substitute for the ultimate test of success over time: the economic performance of the business in terms of the cash flow returns generated through sustained profitability, as measured against the investment base. As we’ll show throughout this book, and especially in the last six chapters, when interpreting the performance of a business one must make a clear distinction between accounting results and economic results. The former are based on generally accepted accounting principles (GAAP), under which all publicly held businesses in the United States are required to record their transactions, and report their financial position and operating results. The latter represent a translation of these accounting data and results into a basic cash-in, cash-out framework, which is used to establish the ultimate test of economic performance and value creation. Both types of results, of course, depend on sound management of every aspect of the company, except that cash-flow based principles and tools give much more direct decision support and economic meaning to performance evaluation and value creation. Both sets of measures and tools have their place in business analysis, depending on the circumstances of their use. Over the past two decades there has been a growing shift in the direction of cash-flow based principles and measures, inflation-adjusted and applied across time and geographic boundaries. We believe this to be a sound development for better decision-making and investment analysis. Returning to the new economy argument that profitability is old-fashioned, we can only say that such a mind set is a denial of the obvious. In the last several years it was often argued that an ascending company showing profits was somehow in the wrong, that huge deficits and negative cash flows were signs of progress in the competitive game, and many market valuations were based in a perverse way on such criteria. Yet, for over a century it has been established that the viability of any business depends on earnings, over time, at levels above the cost of capital of the investment committed. This is nothing more than rudimentary economics, which is ignored by the argument about profitability not being relevant. There are, of course, many ways to interpret profitability, as we’ll see, be it in accounting or economic terms. But one must interpret it—whether one is a financial analyst, a corporate manager or staff person, a banker, a venture capitalist, a business adviser, or an individual investor. And it is here that the new economy thinking has attempted to sweep away a fundamental principle, to the regret of countless shareholders whose stake in the ballooning valuations was brought back to earth by the inexorable gravity of unsupported profit and cash flow expectations.
The Basics Never Change At the time of this writing, a very important and encouraging process is taking place, namely, a rediscovery of basic management principles and of the matching set of analytical tools and concepts. The stock market has deflated a significant
Team-Fly®
hel78340_ch01.qxd
9/27/01
10:57 AM
Page 7
CHAPTER 1 The Challenge of Financial/Economic Decision-Making
7
part of the speculative bubble of the last three years (with the NASDAQ declining below 50 percent of its peak level), a slowing economy requires the stimulus of sizeable interest rate cuts and tax reductions, and a significant downsizing of corporate earnings expectations is taking place. All of these forces have contributed to a climate in which investors, analysts and managers alike are again turning to the time-tested ways of thinking about performance and valuation, and acting in accordance with them. The notion that valuations of newer companies can be established through earnings multiples that defy gravity has receded; similarly, financial commentaries have begun again to stress the importance of earnings and cash flows. This trend is accompanied by renewed attention being given to the economic trade-offs involved in analyzing business decisions, whether strategic, operational or financial. One is reminded of an often used simile, the wheel of fashion, which turns slowly, and where any spot on its rim eventually returns to the original position in cycle after cycle; whether it be skirt lengths or the width of men’s ties, or dressing down or dressing up, the fashion cycle rotates. We can find a parallel in business practices and analytical concepts. In recent memory, the hectic “anything goes” conglomeration and merger period of the late 1960s into the ’80s was followed by a sobering decade of restructuring and divestiture, supported to a considerable extent by the rapidly emerging new shareholder value analysis concepts and tools. Economic cash flow methodologies and trade-offs were at the heart of this reversal, and while they were expressed in new and advanced computer-aided forms, their guiding principles harked back to the economic axioms of a century or more. The waning years of the last decade of the twentieth century, to which Federal Reserve Bank Chairman Alan Greenspan’s earlier characterization of investor behavior as “irrational exuberance” could certainly be applied, are being followed again by the nth rediscovery of time-tested principles. These are simple but critical maxims such as earning returns above the cost of capital, recovering investments within a foreseeable time frame, making prudent decision trade-offs, and developing careful risk assessments in business situations both new and old. Financial/economic analysis never loses its basic importance—only the degree of attention paid varies over time, with the performance of the economy, changes in investor psychology, investment advisor hype, management ambition, and entrepreneurial verve.
The Economic Manager Given our emphasis on basic economic principles and the time-tested approach to financial/economic analysis, we prefer to think of successful managers at all levels as economic managers. This appellation certainly doesn’t imply requiring a degree in economics, or a stint in an economic consulting firm. Instead, we define the economic manager as a person operating from a mind set of deliberate economic trade-offs, applied to every decision made. This mind set always leads to
hel78340_ch01.qxd
9/27/01
10:57 AM
Page 8
8
Financial Analysis: Tools and Techniques
the question: “What are the ultimate cash flow benefits to be derived from this action, and what are the cash flow commitments involved—is this trade-off appropriate, given the risks involved?” There is a degree of basic common sense about this point of view, because whether knowingly, instinctively, or even subconsciously, just about all individuals make such trade-offs in their daily lives. We all have a sense of weighing value received for value given in our purchases or investments, or in reverse, of value given for value received when we sell assets, or our own services. It’s only the degree of understanding, quantification, and analytical discipline applied in practice that distinguishes the economic manager from the average individual, and we’ll discuss the key attributes in a little more detail.
Understanding Business Economics The economic manager has a very clear understanding of the business economics of the company and its parts, and especially of the segment he or she manages. This understanding begins with the dimensions and implications of the business model used, including customer needs and attributes, the supply chain, competitive positioning, and the company’s operational design and effectiveness, all within the larger societal setting. It extends to insights about the specific contributions and requirements of the various stakeholders, and the obligations the organization owes them. With such solid background knowledge the economic manager is in a position to identify and prioritize key value drivers that are essential to the longterm success of the business. A value driver can be as basic as a sustainable cost and/or quality advantage due to a patented process, a protected resource, or a unique set of operational skills. It can be as intangible as the technical expertise of a product development team or a group of service providers, or it can be an attribute of the business model that is hard for others to emulate. Positioning on the preference spectrum of the customers, such as brand name, or enjoying the advantage from an installed base of products or services can be value drivers. The point is, most businesses can identify one or more of these, and if properly addressed, managed, and measured they can lead to a tangible advantage or at least acceptable results. In the end every value driver is a lever for improved cash flow performance, and the economic manager will be very familiar not only with the nature of the value drivers impacted by decisions, but also the trade-offs to be made in using the drivers well. Thus the economic manager views the business not only as a complete system, but also as a finely tuned assembly of interrelated parts. The economic manager knows where the priority areas of attention are and how to enhance them, and understands the business model and its parts sufficiently to have a positive impact through carefully analyzed and executed decisions. Parallel to this understanding is the economic manager’s comfort with the decision-making process itself. The mind set is oriented toward clearly defining the issue at hand, establishing the appropriate alternatives, identifying which
hel78340_ch01.qxd
9/27/01
10:57 AM
Page 9
CHAPTER 1 The Challenge of Financial/Economic Decision-Making
9
information and data are relevant for the purpose, and judging the analytical results from a long-term viewpoint of value creation. The economic manager is sufficiently familiar with information sources within the company, and works in close collaboration with financial and other staff persons to make sure that relevant data are at hand for sound analysis and judgments. There’s sufficient understanding of such data to know what to ask for, to judge whether data or analyses provided by others are truly relevant, and to hold one’s own in discussions with specialized personnel whose job it is to delve into the details of analytical data, constructs, and tools. We’re talking about a level of practical insight that stops well short of the intricate specialization implicit in accounting, economic analysis, and planning expertise, but which is pronounced enough to insist on and achieve justifiable approaches and answers. The economic manager thus actively and successfully merges practical line experience with effective use of available staff capabilities.
Appropriate Economic Tools Specifically, the economic manager knows the major tools for economic analysis well enough to be comfortable with their application and the interpretation of the results achieved. This is part of a deliberate effort to take responsibility for the process, and to draw in assistance from specialized staffs as needed. It’s a natural aspect of managerial leadership to be cognizant of the need to apply the best techniques whenever necessary, and to base the choice on the cost benefit trade-off involved in such an effort. Once appropriate analytical tools to prepare the groundwork for a decision have been identified, the role of the economic manager becomes that of decisionmaker—one who guides the process, probes for the appropriate information, and challenges the preliminary results and insights presented by staff, until a level of comfort is reached with the output of the analysis. Practicality is paramount at all times, as is realism stemming from the collective experience of the players involved. In line with this principle, for example, we’ll discuss in Chapters 7 and 8 not only the technical aspects of the investment analysis tools presented there, but also frame their meaning and use in the larger context of the decision process involved. Economic tools must be an extension of management practice, not an exercise in number crunching. The economic manager embracing such an approach will be in a better position to interpret and argue the case for a significant initiative with the ultimate decision-makers, whether senior executives or even the board of directors. The manager’s involvement in the framing of the issue, the choice of tools, and guidance of analytical effort leads to greater effectiveness not only in the manager’s ability to handle decisions large and small, but also, by virtue of the manager’s leadership, in the organization’s ability to operate the business by appropriate economic criteria and by making the necessary trade-offs. This is, of course, a prerequisite for the value-creating company we address next.
hel78340_ch01.qxd
9/27/01
10:58 AM
Page 10
10
Financial Analysis: Tools and Techniques
The Practice of Financial/Economic Analysis The financial/economic analysis sponsored and used by the economic manager can be viewed within a broad hierarchy of decision-making needs. The diagram in Figure 1–1 shows four key areas in the typical business where financial/economic analysis is a necessary ingredient. This conceptual pyramid rests on the broadest area: day-to-day decisions and operational planning. It successively rises via strategy development, investment analysis and capital structure planning, on to performance assessment and incentives, and finally to valuation and investor communication. Each of these areas contains challenges and issues in the practice of analysis and decision-making that the economic manager must address.
Day-to-Day Decisions and Operational Planning One of the most important areas of applying basic financial/economic analysis is the support of day-to-day decisions made by managers and employees. We’re talking about the operational part of the enterprise, in which strategic direction and operational plans are translated into action. Despite its importance, analytical practice in this area often tends to be the least developed, because the pressure of daily activities foreshortens the time for reflective thinking about operational issues and trade-offs. Too busy to ponder the impact of a decision on the bottom line, the harried manager or employee acts on the spur of the moment. Such seatF I G U R E 1–1
Areas for Financial/Economic Analysis
Valuation; Investor Communication Performance Assessment; Incentives Strategy Development; Investment Analysis: Capital Structure Planning & Financing Operational Planning; Day-to-Day Decision-Making
hel78340_ch01.qxd
9/27/01
10:58 AM
Page 11
CHAPTER 1 The Challenge of Financial/Economic Decision-Making
11
of-the-pants decision-making can become the ingrained way of doing things, unless the company has instilled a basic sense of decisional discipline and provided guidance through simple but useful decision rules and processes. The successful company will have an integrated set of metrics and criteria, and provide information that clearly supports intelligent decision-making. Without such guidance, non-economic and damaging choices such as spending funds because there’s room in the budget or in the allowable head count become decision criteria. Operational effectiveness should be a function of sound trade-offs, with careful cost management and close attention paid to the quality and efficiency of production or services rendered, and with constant vigilance in serving customers through sustainable pricing, credit, and support actions. While this book contains a large number of the key tools and measures to assist in making such trade-offs, the issue we’re addressing here is larger than availability of tools. We’re talking about a mind set, an organizational climate in which managers and all employees are encouraged, indeed challenged, to approach their jobs and the daily decisions they make with a rational trade-off mentality. Before making a decision, answers to questions such as “Is this really a necessary outlay and will it bring in more cash than I will spend?” or “Should I in fact spend more because I expect an opportunity to improve service will pay off in higher profit contribution?” should be second nature, as would the deliberation: “Should I engage in this activity, or is it more economical to have it performed by an outside service?” Such thinking might run counter to a corporate culture which does not encourage employee initiative and “thinking outside the box,” but will be a natural consequence of the leadership of the economic manager we discussed earlier. It’s reinforced by a combination of training and specific decision support, and clearly communicated expectations at all levels.
Supporting Strategy Development The practice of financial/economic analysis is generally more developed in this area, as it is subject to more senior management scrutiny and authority because of the size and implications of the decisions made. Also, support by qualified internal staff or outside advice is often available. Yet, as we discussed earlier, there are significant exceptions to this in new economy companies; but even old economy businesses are certainly not uniform in the quality of analytical processes they employ in these areas. The analysis of strategic alternatives and the commitment of resources to investments involves a complex set of economic trade-offs, viewed within a competitive framework. The ultimate goal is to find areas of activity that can be performed with a sustainable competitive advantage. The major challenge lies in establishing the key variables involved, making estimates of the risks surrounding them, and ultimately expressing the likely alternatives in the form of expected cash flow patterns. This is a difficult undertaking, where the problem is not so much the eventual application of the economic tools, but the development of
hel78340_ch01.qxd
9/27/01
10:58 AM
Page 12
12
Financial Analysis: Tools and Techniques
a coherent structure of the proposal, its relevant alternatives, and all of its key variables and the risks expected. It is here where judgment and interpretation are critical, that is, clearly defining the opportunities and choices to be made, and thinking through all the implications of a potential decision on the existing organization, on the customer base, on the competitive situation. It is also here where experience shows that profit expectations can be overblown, that the difficulties of implementation can be underestimated, and that market acceptance of an initiative might not materialize. This is not only true when introducing a new business model, as we mentioned, but is especially prevalent in mergers and acquisitions, which more often than not fail to create value because economic analysis becomes secondary to bidding contests and resultant overpricing. Economic managers will insist on creating and assessing a range of risk-adjusted summary cash flow estimates for any strategic change, perhaps based on different scenarios, as the basis for weighing the strategy’s ultimate economic impact and value contribution. The analysis of the current and prospective financing structure similarly involves many economic trade-offs, integrating the degrees of risk connected with various financing options with their costs and the long-run viability of the capital structure. Key influences are the rate of growth envisioned in the business, the trade-off between internal growth versus acquisitions and partnering, domestic versus global operations, and the nature of the main business activities themselves and their attendant risks. None of the choices of funding sources are obvious, and the economic impact on the business as well as on share values must be judged carefully. The role of informed judgment in gauging risks versus rewards, while not fully quantifiable in itself, is a critical requirement in, for example, avoiding credit problems, or financing constraints that can interfere with strategy. In the end, the role of financial/economic analysis in strategy development and financing should be seen as an integrative force. Applied properly, it leads to testing as closely as possible the planned strategic structure of investment and necessary financing against the goal of earning above the cost of capital, and creating shareholder value.
Performance Assessment and Incentives The main issue in this area is the relevance of the measures to the goals set, and the need to establish not only indicators of deviation from desired norms, but also to interpret these indicators so they can be used to reinforce value creation. It’s an area where the quality of the concepts and tools employed varies widely in both established and new companies. If the relevance of measures employed has not been clearly established in an organization, performance data can be meaningless, or subject to manipulation. “Gaming” the budget or the business plan is an ever-present temptation. The tools for analysis, and the judgments required for interpreting performance vary widely, whether one measures performance from outside the business, which is the task of investors, creditors, and suppliers, or
hel78340_ch01.qxd
9/27/01
10:58 AM
Page 13
CHAPTER 1 The Challenge of Financial/Economic Decision-Making
13
internally, which is a necessary function of managing the various levels and segments of a company. One of the critical challenges in evaluating the performance of a business from the outside is to interpret the results as expressed in financial statements. These are the most readily available data for publicly held companies. But the various ratios and measures that can be applied to this information are subject to limitations inherent in the financial accounting process and to a number of choices management has in applying its rules and thus “managing” the reported results. The outside analyst endeavors to measure operational effectiveness, the success with which capital has been employed, and the risks represented by the capital structure and its parts. Measures and their meaning vary by industry segment and type of organization, and the challenge is always to derive insights from relevant comparisons to other companies or groupings, a difficult task in most instances. The ratios and relationships used as measures are easy to derive, but their effective use depends on the skill of the analyst in interpreting trends and recognizing exceptions and changes due to management actions or accounting policies. The sophisticated analyst is able to look beyond accounting results to make an evaluation of cash flow patterns underlying the data made available, as we’ll observe frequently throughout the book. Performance evaluation within the organization benefits from access to more detailed and current information, which usually goes far beyond publicly released data. But here the challenge is to develop measures that represent the cause and effect between decisions made and results achieved, a challenge not fully addressed in many situations. A vast range of statistical data can be used to measure effectiveness of operations, many of which are physical in nature, such as output data, failure rates, yields, customer contact frequencies, timeliness information, and project completions. Intangible data such as customer satisfaction, employee attitudes, and community feedback are important supplements. The point we’re making is that financial performance begins with the roots of operational activity, and evaluating financial ratios and measures must rest on an understanding of these activity-based indicators. In well-managed companies there is a close connection between physical and financial indicators, and performance evaluation is made with this total view of the operation. This recognizes that accounting transactions and their compilation provide at best a partial view, and that financial measures have to be supplemented with judgments about organizational activity. When it comes to internally assessing the effectiveness with which capital has been employed by various parts of the organization, accounting measures tend to loom larger. Rate-of-return measures and other criteria that we’ll discuss represent a summarized, periodic view of net benefits, usually after-tax profit, versus the recorded resources employed. Here the potential deviation from economic results is larger, and many companies are attempting to move closer to the cash flow measures we’ll discuss in the latter portion of the book. There has been a steady evolution in these processes, in parallel with a better understanding of the economic dynamics of the securities markets.
hel78340_ch01.qxd
9/27/01
10:58 AM
Page 14
14
Financial Analysis: Tools and Techniques
Incentives to enhance short- and long-term performance are the opposite side of the performance evaluation challenge we just discussed. We won’t deal directly with the complex issues of designing incentive programs, as this is a subject deserving full treatment by itself. However, the principles of decision-driven management we support, the focus on cause and effect in making appropriate trade-offs, and the need for long-term cash flow generation will echo through a well-designed incentive system. Operational, largely activity-based incentives for employees are less difficult to design, because of their direct, statistical underpinnings. More challenging are higher level finance-based incentives, which due to their more encompassing nature and usual reliance on accounting data, can introduce problems of interpretation and opportunities for “gaming.” How periodic revenues are recorded, and expenses are recognized can affect the outcome of such measures and the resulting payout to the manager. There is also the issue of the time horizon over which incentives are established. The higher the level of management, the more emphasis should be given to long-term cash flow generation, to avoid the temptation for making short-term trade-offs that damage longrun value creation. Finally, there is the always present issue of how high to set the standard to ensure some degree of excellence and significant effort, without making the incentive unachievable. In short, incentives represent a form of using financial/economic analysis heavily overlaid not only with challenges of interpretation but of human motivation and proper rewards.
Valuation and Investor Communication The most integrative aspect of financial/economic analysis is the area of valuation and investor communication. It is here that some of the most complex tools and methodologies are commonly employed, and it’s also the area where much of the theoretical and empirical research of the past two decades has been focused. As we’ll discuss in the final chapters, valuation is a function of the expectations held by the company’s existing and potential investors, and by the securities markets in general. There is a two-fold challenge involved in this analytical area. First, outside analysts and managers alike must understand and properly apply the principles of valuation we’ll discuss. Second, the story of the company’s performance and future expectations has to be made available and explained—obviously within the legal and regulatory constraints to which such communication is subject—in a way that reasonable assumptions can be derived from this information. Because valuation by necessity is a future-oriented process, existing performance must be projected over a time horizon befitting the nature of the business and its industry segment. This is best done in a cash flow framework to which various tools are applied to derive ranges of valuation, although short-cut methods can of course be used for “ballpark” estimates. Thus the challenge is quite daunting: It begins with understanding the business model and its key attributes, an appreciation of the strategies in place and any changes expected, an assessment of key performance criteria, a feel for the competitive realities and the future environment of the indus-
hel78340_ch01.qxd
9/27/01
10:58 AM
Page 15
CHAPTER 1 The Challenge of Financial/Economic Decision-Making
15
try, and a judgment about the position and likely success of the company within this environment. We again are faced with a systems view of financial/economic analysis at the highest level, which integrates the insights about all aspects of the business under review. The external communication challenge similarly requires a systems view of the company’s performance and prospects. In both the analytical and communications areas a fully integrated approach is still lacking in the majority of corporate situations, and we began this chapter by saying that there was an obvious hiatus during the excesses of the dot.com era. The rediscovery of basic economics is coming none too soon for this important area of analysis.
The Value Creating Company While we’ve already brought up most of the requirements for creating economic value through economic management, let’s reflect briefly on what the key attributes of a successful company are. In our view, the value creating company can be defined as an organization in which management has achieved integration of the interests and actions of its key stakeholders, that is, shareholders, managers, employees, customers, suppliers, creditors, and the community. This integration is based on managing, through sound decision-making, the business system we’ll describe in Chapter 2, and the many economic trade-offs implicit in this system. Such a company achieves, as nearly as possible, an optimization of the system’s performance over time, driven by a sound business model, strategies with a sustainable competitive advantage, and superb operational execution, supported by an appropriate, balanced capital structure. This should result in achieving positive cash flows as well as expectations of future cash flow patterns that exceed the cost of capital. In turn, this will provide superior returns to shareholders, superior rewards for managers and employees, excellence in customer satisfaction, first rate performance and loyalty from suppliers, and superior credit relations. Financial/economic analysis properly applied plays a key role in all of these aspects, and we’ll discuss some of the underlying requirements.
Relevant Decision Information No sound decisions are possible in a business setting without relevant information being available to the decision-maker. This axiom applies to all types of decision situations, whether large or small. The value creating company has established information sources and access to this information to enable persons at all levels to make rational trade-offs, whenever faced with an issue to be decided. This requires several supportive management practices: • Sharing of relevant information. • Decision support by financial staff. • Distinction between accounting and economic data.
hel78340_ch01.qxd
9/27/01
10:58 AM
Page 16
16
Financial Analysis: Tools and Techniques
Sharing. The first practice is a deliberate management attitude of sharing. Too often old economy companies have fostered a climate in which information and knowledge is limited to those “in the know,” while new economy companies often have been too busy to even develop appropriate information flows. The principle here is one of delegation, of entrusting people at all levels with relevant data that will help them make sound decisions in the interest of value creation. This fits well with the modern management concepts of flat organizations and empowered employees. Empowerment begins with knowledge and is expanded by targeted training, which includes understanding the nature and relevance of financial/economic data, and is reinforced by a climate of trust.
TE
AM FL Y
Decision support. The second practice defines the support role of financial staffs in the organization. If sharing of information and its appropriate use is to succeed, the financial staffs must be proactive, because they are the basic supervisors of transactions and data collection, sponsors of internal information and accounting systems, and guardians of financial information. Again we’re describing a mind set, a shifting away from the primary attitude of control and stewardship—which historically has been the orientation of accounting professionals—to an attitude of business advisor and facilitator of decision support. The significance of this shift cannot be overemphasized. The value creating company looks upon its qualified financial staffs as business consultants, working closely with the line managers—our economic managers—and bringing to bear their insights and access to information in order to empower the decisionmakers up and down the line to make appropriate trade-offs. This is an educational function as well as a support role, because even when information is shared, it’s necessary to explain the meaning and relevance of the financial/ economic data, and to assist the non-financial personnel in the appropriate use of decision criteria and tools. At the same time, as we observed earlier, nonfinancial managers must not simply delegate the analytical aspects of their economic decisions to the experts, because understanding the principles involved as well as being clear about the nature of the trade-offs is part of the overall effectiveness of the enlightened modern manager. Accounting versus cash. The third practice is related to the first two, and also echoes an important theme mentioned earlier and carried throughout this book. The value creating company has managed to draw a clear distinction between the two points of view with which financial information is gathered and interpreted, namely, the accounting viewpoint and the economic decision viewpoint. The blurring between these two, which is too often found in financial analysts’ commentary and security analysts’ reports, can lead senior management to pursue results in accounting terms, such as managing quarterly earnings results and expectations, when in fact cash flows are increasingly being recognized as the real key to building value. The value creating company encourages internal decision-making on the basis of managerial economics and cash flow
Team-Fly®
hel78340_ch01.qxd
9/27/01
10:58 AM
Page 17
CHAPTER 1 The Challenge of Financial/Economic Decision-Making
17
data, tasking the financial staffs to develop decision rules and decision information, and provide support that clarifies the economic trade-offs to be made. In this process, such a company certainly doesn’t ignore the requirements of financial accounting and reporting, which are still the mainstay of published financial information. But the company actively promotes, in parallel fashion, the view of its performance in cash flow terms, and embraces appropriate shareholder value techniques of the kind described in the final chapters of this book. As it sends clear signals to its personnel that decision-making must be economic and cash trade-off oriented, it also requires that the accounting implications are to be recognized as a separate view. At times, divergent near-term accounting impacts might have to be explained in external communications, if a strategic move is at stake which could depress near-term reported earnings but promises strong cash flow results over time. The value creating company does this as a matter of course, confident in the integrity of its decision-making processes, and communicating clearly why financial accounting cannot express the true economic results, given its different orientation. In short, the value creating company has established a corporate climate in which all decisions and all actions are viewed as economic trade-offs, and which fosters access to and sharing of carefully developed, relevant information, decision rules, and tools in a collaborative fashion. Because the common objective is value creation for the long term, such a supportive climate for decision-making is the vital underpinning of success.
Economic Incentives One of the critical attributes of the value creating company is the degree of attention paid to providing appropriate near-term and long-term incentives to its managers and employees. As we mentioned earlier, there should be a true causeand-effect phenomenon surrounding incentives and results. If a company’s incentives are based on some of the common, broad accounting measures such as return on equity, or return on assets, or even earnings per share, there is a real risk that decisions, large and small, will suffer from the economic disconnect and time lag inherent to these measures, as we’ll discuss in the final chapters of this book. While the complex subject of management incentives is not one of the areas we’ll cover, we believe the principles involved are the same basic economic choices that affect financial analysis and planning. Therefore, both near-term and long-term incentive programs should reflect a careful set of measures designed to reinforce shareholder value creation. Since value creation depends on consistent cash flow generation in excess of the cost of capital, incentives chosen will tend to reward results from consistent cash-flowbased decision-making. Targets are set and measured with yardsticks as close as possible to cash. As we said earlier, this approach is directly applicable in the operational area, where the cause-and-effect relationship between incentives and results can be found in fairly basic targets, such as volume goals in sales or
hel78340_ch01.qxd
9/27/01
10:58 AM
18
Page 18
Financial Analysis: Tools and Techniques
production, carefully calibrated against quality standards and relative contribution from products and services, or cost effectiveness standards that encourage enhanced performance within required service and quality levels. We’re not talking merely about managing budgetary variances, but about setting specific sub-goals within a broader set of systematic expectations, accompanied by open communication about the fit of these sub-goals into the overall strategic context. The process in effect focuses on identifiable and measurable value drivers, which we mentioned earlier. In the strategic area, long-term incentives should primarily be based on the cash flow expectations from specific plans, whether for a product or service sector in the business, or for the company as a whole. In essence, incentives are founded on the ability to bring about the cash flow streams committed to in strategic plans, and rewards fluctuate in response to such performance. The value creating company structures true incentives, that is, underperformance means a tangible penalty, while excellence is well rewarded. In addition, there is great emphasis on long-term performance to avoid the temptation to make decisions that enhance short-term results to the detriment of shareholder value creation.
Total Systems Management As we’ve mentioned before, and as we’ll illustrate in much more detail, the most important attribute of a successful, value creating company is its deliberate emphasis on managing the company and its parts as a total system. In simple terms, this means that there is coherence and positive, economic reinforcement reaching across all operational, investment and financing activities. The pattern of strategies and policies chosen is well-matched with the purpose and core capabilities of the company and its stakeholders. Senior management constantly monitors and reinforces this systems view through its feedback and actions, and stands ready to remedy any conflicting actions that could detract from the aim to optimize the overall system. Every major decision, whether affecting operational execution, investments, acquisitions or disinvestments, or financing choices and funding sources, is made within the systems context to ensure that all implications and linkages are considered and the appropriate trade-offs established. Decision rules and practices for day-to-day decisions are calibrated to reflect the systems view as well. To achieve such integration of corporate purpose, strategies, policies, activities and decision-making is not an easy task. Only a few companies experience it fully and consistently, but it is here where the attributes of the economic manager we discussed can be applied most effectively. It requires constant vigilance and communication, as well as very consistent management behavior with responses that match this image. The rewards to shareholders, managers and other stakeholders are obvious, when value creation at the levels of, say, General Electric is considered. Every management team must ask itself from time to time whether it
hel78340_ch01.qxd
9/27/01
10:58 AM
Page 19
CHAPTER 1 The Challenge of Financial/Economic Decision-Making
19
is managing the system entrusted to it by the shareholders in a coherent systems manner, and financial/economic analysis as we’ll discuss it in this book is a critical component supporting this integrated approach.
Summary In this chapter we’ve attempted to provide a broad, introductory perspective for the role and the challenges of financial/economic analysis in the modern business setting. We started by characterizing the attributes and issues of the new economy, and the recent welcome return to the unchanging basics of analyzing and understanding business performance and prospects. Then we stressed the need for all managers to become economic managers to best fulfill their and their companies’ potential, and discussed some of the key issues in using financial/ economic analysis within the general hierarchy of business management. In each of these cases we referred to the challenges posed by current or emerging practice. We ended with an overview of the critical attributes of the successful, value creating company. This was a reemphasis of the critical need for a systems approach to economic management, the theme that is being carried throughout this book.
This page intentionally left blank.
hel78340_ch02.qxd
9/27/01
10:59 AM
Page 21
CHAPTER 2
A SYSTEMS CONTEXT FOR FINANCIAL MANAGEMENT
A
ny business, large or small, is a system of financial relationships and cash flows, which are activated by management decisions—a key principle we established in Chapter 1. This concept gained importance in the 1990s, when creation of shareholder value emerged as a critical performance challenge and became one of the primary goals of modern management. Creating shareholder value depends on bringing about a positive pattern of cash flows in excess of investor expectations. A business that is successfully managed in all parts as an integrated system will generate such cash flows over time and well into the future—thus becoming a value creating company. Given that the basic purpose and value of business activity depend on longterm cash flow generation, it’s necessary for us to understand more specifically how the dynamics of the integrated business system work. Moreover, we must directly relate the various analytical concepts and tools we’ll discuss in this book to the business system. As we observed, they should assist decisionmakers at all levels in specific ways to support cash flow generation and shareholder value creation. Finally, we must provide an appropriate context for the use of commonly available financial information with which such analytical activity is supported. In this chapter we’ll expand the picture we’ve developed in the previous chapter, by presenting three conceptual overviews for the context and meaning of financial/economic analysis and the key economic trade-offs it supports. The purpose is to provide the reader with a realistic structure that goes beyond mere coverage of technical tools and methods: •
A graphic representation of the generalized, integrated business system, showing the relationships and dynamics of the three basic management decision areas which are common to all organizations which have an economic purpose: Investment decisions. 21
Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
hel78340_ch02.qxd
9/27/01
10:59 AM
Page 22
22
Financial Analysis: Tools and Techniques
Operating decisions. Financing decisions. • A broad perspective of the nature, meaning, and limits of the major published financial statements, which are the primary source of financial data, and their relationship to the business system: Balance sheets. Income (operating) statements. Cash flow statements. Statements of changes in shareholders’ (owners’) equity. • A generalized overview of the key analytical processes used in interpreting the performance and value of the business system, grouped by three major viewpoints: Financial accounting. Investor analysis. Managerial economics. In our discussions we’ll continue to differentiate between purely financial analysis on one hand, and economic analysis and trade-offs on the other. As we mentioned, the first is largely based on financial statements and accounting data, while the second focuses on cash flows. We make this important distinction because the tasks of analyzing, judging, and guiding a firm’s activities are far broader and more complex than the mere manipulation of reported financial data. Ultimately, the performance and value of any business must be judged in economic terms; that is, expressed in cash flows achieved and future cash flows expected. Yet, we must remind ourselves that much of the available data and many of the analytical techniques generally used are based on financial accounting and its special conventions, which by their nature don’t necessarily reflect current and future economic performance and value. Therefore, the manager or analyst must at all times carefully interpret and even translate the available data to properly match the context and purpose of the analysis. It’s the both the manager’s and the analyst’s duty to make sure that the process selected and the results obtained in any analysis clearly fit the desired objectives, whether they express a financial viewpoint or an economic insight when judging performance, expectations, or valuation.
A Dynamic Perspective of Business Decision Context As we’ve established, successful operation, performance, and long-term viability of any business, depend on a continuous sequence of sound decisions made individually or collectively by the management team. Every one of these decisions
hel78340_ch02.qxd
9/27/01
10:59 AM
Page 23
CHAPTER 2 A Systems Context for Financial Management
23
ultimately causes, for better or worse, an economic impact on the business. In essence, the process of managing any enterprise requires ongoing economic choices; each time trading off costs and benefits. These choices in turn activate specific, identifiable shifts in the physical and financial resources supporting the business. Ultimately these shifts cause movements of cash, which is the final economic result. For Example Hiring an employee means incurring a future series of salary or wage payments in exchange for useful services. Selling merchandise on credit releases goods from inventory to the customer and creates a documented obligation by the customer to remit payment within 30 or 60 days. Investing in a new physical facility causes, among other effects, a potentially complex set of future financial obligations to be fulfilled. Developing a new software application involves a significant period of cash commitments for salaries, technical support, and testing before marketing efforts result in a revenue stream. Successful negotiation with a lender for a line of credit brings an inflow of cash into the business, to be repaid in future periods. Some decisions are major, such as investing in a new manufacturing plant, raising large amounts of debt, or adding a new line of products or services. Most other decisions are part of the day-to-day processes through which every functional area of a business is managed. We earlier established the common theme that all decisions are economic trade-offs; that is, before a decision is made the decision maker must weigh the cash benefits expected against the cash costs incurred. In normal day-to-day decisions, these underlying trade-offs can be quite apparent and identifiable. In complex situations, however, managers must carefully evaluate whether the net pattern of resources committed directly or indirectly by the decision is likely to be profitably recovered over time through the changes in revenues and expenses caused by this commitment. Managers also must identify the relevant information needed to support this analysis. The collective effect of the series of trade-off analyses and decisions ultimately impacts both the performance and value of the business. Results are then judged periodically, either by means of financial statements or with the help of special economic analyses. Fundamentally, managers make decisions on behalf of the owners of the business, while addressing the interests of the various stakeholders involved, that is employees, suppliers, creditors and the community. In this process, managers are responsible for effectively deploying available internal and external resources in ways that create an economic gain for the owners—a gain reflected over time in the combination of dividends and share price appreciation received by the owner/shareholders. This concept, called total shareholder return (TSR), is one of the key criteria for measuring the success of the company relative to its peers and the market as a whole, as we’ll discuss in Chapters 4 and 12.
hel78340_ch02.qxd
9/27/01
10:59 AM
Page 24
24
Financial Analysis: Tools and Techniques
Despite the great variety of issues faced every day by managers of different businesses, and within the hierarchy of business activities we discussed in the first chapter, management tasks are so similar in principle that we can effectively group all business decisions into three basic areas: The investment of resources. • The operation of the business using these resources. • The proper mix of financing that funds these resources. •
Figure 2–1 reflects the continuous interrelationship of these three areas. Today’s business world has infinite variety. Enterprises of all sizes engage in activities such as trade, manufacturing, finance, and myriad services, using a variety of business models, and legal and organizational structures. They frequently involve international operations, far-flung investments and internet support. Common to all businesses, however, is the following definition of the basic economic purpose of sound management: Strategic deployment of selected resources in order to create, over time, economic value sufficient to recover all of the resources employed while earning an acceptable economic return on these resources under conditions that match the owners’ expectations of risk. Over time, therefore, successful resource deployments should result in a net improvement in the economic position of the owners of the business. Only when such an improvement is achieved has additional shareholder value been created, as we’ll discuss later. The primary effect of value creation normally will be a higher valuation of the business. If the company’s stock is traded publicly, its value is judged by the securities markets. If the company is privately held, its value will be reflected in the price offered by potential buyers of the business. If no value increment is achieved over time, or if there is a declining trend, the firm’s economic viability might be in question.
F I G U R E 2–1
The Three Basic Business Decisions Investment
Financing The three decisions areas for making appropriate economic trade-offs
Operations
hel78340_ch02.qxd
9/27/01
10:59 AM
Page 25
CHAPTER 2 A Systems Context for Financial Management
25
Therefore, creating shareholder value ultimately depends on properly managing the three basic decision areas common to all organizations Selecting, implementing, and monitoring all investments based on sound, sustainable strategies, economic analysis and effective management. • Guiding the operations of the business profitably through proper tradeoff decisions and cost-effective use of all resources employed. • Prudently financing the business by consciously trading off the rewards expected against the risks encountered in balancing internal and external financing in the capital structure. •
Making successful economic trade-offs in all of these decisions is fundamental to driving the value creation process. These trade-offs must also be explicitly chosen and managed in a consistent way to achieve long-run success, instead of focusing on occasional short-term improvements that cannot be sustained or might detract from longer-term results. Figure 2–2 depicts the definition and purpose of the three interrelated decision areas. As we observed earlier, the basic task—and the fundamental challenge—of financial/ economic analysis lies in constructing and sharing a reasonably consistent and meaningful set of data and relationships that will support the decisionmaking process for the purpose of value creation. If this is done well, the chosen frameworks and tools should enable the analyst and the manager to judge the economic trade-offs involved in investment choices, financing options, and operational effectiveness, and help define and judge the company’s economic performance, future expectations, and value. Figure 2–3 illustrates, in the form of background layers, the analytical framework and tools, data sources, and the general backdrop of competitive and economic conditions to the three decision areas. This picture presents an integrated set of concepts for the ideal interplay of management decisions and the interpretation of results. F I G U R E 2–2
The Process of Value Creation Selecting and making sound resource commitments
Selecting and sourcing prudent funding options
Creating economic value for the shareholders Operating all resources in a competitive, cost-effective manner
hel78340_ch02.qxd
9/27/01
10:59 AM
Page 26
26
Financial Analysis: Tools and Techniques
F I G U R E 2–3
The Broad Context of Financial/Economic Analysis Economic and competitive environment Data sources Analytical framework and tools
Investment effectiveness
Financing effectiveness
AM FL Y
Overall results and value creation
TE
Operational effectiveness
The Business System
As we know, there’s a dynamic interrelationship among decisions made by managers. Decisions cause resource movements in various forms that ultimately change the cash flow pattern of the business as a whole. The process might involve some intermediate steps before cash movements occur, as we’ll discuss in Chapter 3, but increases or decreases in cash will invariably follow any decision made. We observed that in a successful business, the balancing of cash uses and sources over time generates positive cash flow patterns that lead to the desired buildup of economic value and long-term viability. In fact, creation of shareholder value and cash flow patterns—achieved and expected—are inseparable concepts. As we take up the analytical concepts and tools in the book, we’ll relate them, as appropriate, to the simple principle that “cash in” versus “cash out” is the key to any economic analysis. In Chapter 3, we’ll discuss the formal ways of tracking and analyzing overall resource flow patterns and their cash impact. In Chapters 7, 8, 11, and 12 we’ll show how the specific cash flows associated with an investment project or a business as a whole can be established, analyzed, and valued. Let’s now develop a practical, simplified view of how a typical business operates. With the help of an intuitive systems diagram we’ll demonstrate the basic cash flow patterns, the key relationships, and the key decisions involved in an integrated fashion. Then we’ll show how the major financial/economic analysis
Team-Fly®
hel78340_ch02.qxd
9/27/01
10:59 AM
Page 27
CHAPTER 2 A Systems Context for Financial Management
27
measures and key business strategies relate to this business system. Every one of the measures and concepts will, of course, be discussed in greater depth in the appropriate chapters of this book, but this overview provides a structure for keeping the individual elements in proper perspective. Figure 2–4 presents the basic flow chart of the business system, which contains all major elements necessary to understand the broad cash flow patterns of any business. The arrangement of boxes, lines, and arrows is designed to show that we’re dealing with a system in which all parts are interrelated to each other— and which therefore has to be managed as a whole. The solid lines with arrows represent cash flows, while the dashed lines symbolize trade-off relationships. The system is organized into three segments that match the three major decision areas we’ve defined: investment, operations, and financing. • The top segment represents the three components of business investment: the investment base already in place, the addition of new investments, and any disinvestment (divestment) of resources no longer deemed effective or strategically necessary. In addition, it shows the depreciation effect caused by accounting write-offs of portions of depreciable assets against the investment base and against profits. This box, which effectively enhances the funding potential shown in the bottom segment, represents available cash that was masked when the accounting-based operating profit after taxes was calculated, as we’ll discuss in Chapter 3. • The center segment represents the operational interplay of three basic elements: price, volume, and costs of products and/or services. It also recognizes that usually costs are partly fixed and partly variable relative to volume changes. The ultimate result of the complex set of continuously made trade-offs in the operations area is the periodic operating profit or loss, after applicable income taxes. Operating profit is shown as part of the bottom segment in the diagram, because profit represents one of the key elements of financing the business. • The bottom segment represents, in two parts, the basic financing choices open to a business: 1. The normal disposition of the operating profit after taxes (or loss after taxes) that has been achieved for a period: This is a three-way split among dividends paid to owners, interest paid to lenders (adjusted for taxes because of its tax deductibility), and earnings retained for reinvestment in the business. As the arrows indicate, the cash used for paying dividends and interest leaves the system. 2. The available choices for using long-term capital sources: This reflects shareholders’ equity (ownership), augmented by retained earnings, and long-term debt held by outsiders. Trade-offs
hel78340_ch02.qxd
9/27/01
10:59 AM
Page 28
28
Financial Analysis: Tools and Techniques
F I G U R E 2–4
The Business System: An Overview* New investment Depreciation effect
Disinvestment
Investment
Investment base
Price
Volume
Operations Costs (fixed & variable)
Dividends
Operating profit after taxes
Interest (tax-adjusted)
Retained earnings
Financing Shareholders' equity
Long-term debt
Funding potential
*This diagram is available in an interactive format (TFA Template) – see “Analytical Support” on p. 57.
and decisions that affect the levels of shareholders’ equity, retained profits, or long-term capital sources impact the company’s funding potential, which, as the arrow moving from the left to the top
hel78340_ch02.qxd
9/27/01
10:59 AM
Page 29
CHAPTER 2 A Systems Context for Financial Management
29
indicates, affects the amount of new investment that can be added to the investment base. As was already mentioned, the depreciation effect shown in the top segment enhances the funding potential, because it reflects cash that was masked in the accounting profit calculation. Alternatively, of course, some of the enhanced funding potential can be used to reduce long-term debt, or to repurchase outstanding ownership shares in the market. These actions will, of course, change the capital structure proportions and cause cash to leave the system. Now we’ll examine each part of the business system in further detail to highlight the three types of decisions and the various interrelationships among them.
Investment Decisions Investment is the basic driving force of any business activity. It’s the source of growth, supports management’s explicit competitive strategies, and it is normally based on careful plans (capital budgets) for committing existing or new funds to three main areas: • Working capital (cash balances, receivables due from customers, and inventories, less trade credit from suppliers and other normal current obligations). • Physical assets (land, buildings, machinery and equipment, office furnishings, computer systems, laboratory equipment, etc.). • Major spending programs (research and development, product or service development, promotional programs, etc.) and acquisitions. Note that investment is broadly defined here in terms of resource commitments to be recovered over time, not by the more narrow accounting classification which would, for example, categorize most spending programs as ongoing expenses, despite their longer-range impact. Figure 2–5 shows the investment portion of the systems diagram, accompanied by major yardsticks and key strategies that can be identified in this area. During the periodic planning process, when capital budgets are formulated, management normally chooses from a variety of options those new investments that are expected to exceed or at least meet targeted economic returns. The level of these returns generally is related to shareholder expectations via the cost of capital calculation, as described in Chapter 9. Making sound investment choices and implementing them successfully—so that the actual results in fact exceed the cost of capital standard—is a key management responsibility that leads to value creation. New investment is the key driver of growth strategies that cause enhanced shareholder value, but only if carefully established investment standards are met or exceeded.
hel78340_ch02.qxd
9/27/01
10:59 AM
Page 30
30
Financial Analysis: Tools and Techniques
F I G U R E 2–5
The Business System: Investment Segment Key yardsticks
New investment
• Economic measures – Net present value – Internal rate of return – Discounted payback
• Accounting measures – Return on investment – Return on net assets – Return on assets employed
• Value-based measures – Economic profit – Cash flow return – Cash value added
Depreciation effect
Disinvestment Investment base
Key strategies • Portfolio assessment • Strategic alternatives • Capital budgeting • Priorities and deployment • Acquisitions • Disinvestment
At the same time, successful companies periodically make critical assessments of how their existing investment base (portfolio) is deployed, to see if the actual performance and outlook for the individual products, services, and business segments warrant continued commitment within the context of the company’s strategic posture. If careful analysis demonstrates below-standard economic results and expectations about a particular market or activity, then the opposite of investment, disinvestment, becomes a compelling option. As we’ll see, such poor performing activities destroy shareholder value. Disposing of the assets involved or selling the operating unit as a going concern will allow the funds received to be redeployed more advantageously elsewhere. Also, the sale of any equipment being replaced by newer facilities will provide funds for other purposes. Shareholder value creation thus depends on a combination of ongoing successful performance of existing investments, and the addition of successful new investments—a continued reassessment of the company’s total portfolio of activities. The yardsticks helpful in selecting new investments and disinvestments are generally economic criteria. They are based on cash flows, measuring the tradeoff between investment funds committed now and the expected stream of future operational cash flow benefits, and residual values. The cash flow tools listed here, net present value, internal rate of return, and discounted payback, are discussed in detail in Chapter 7. In contrast, common yardsticks that measure the effectiveness of the existing investment base generally are based on accounting data and relationships, as we’ll describe in Chapter 4. These measures—return on investment, return on assets, and return on assets employed—relate balance sheet and income statement data as basic ratios. We’ll show that there’s a real disconnect between the economic measures commonly used for new investments, and the accountingbased measures for existing investments. This gap in comparability must be
hel78340_ch02.qxd
9/27/01
10:59 AM
Page 31
CHAPTER 2 A Systems Context for Financial Management
31
bridged in order to achieve a consistent approach to shareholder value creation. In fact, this bridging process has been underway since the ’90s with the significant shift of corporate America toward value-based management. Measures such as economic profit, cash flow return on investment, and cash value added have become widely used in judging the performance and value of existing operations. As we’ll discuss in Chapter 12, these measures are cash-flow oriented and thus are comparable to the economic yardsticks used for new investment, which are described in Chapter 7.
Operating Decisions Here key strategies and decisions should focus on effective utilization of the funds invested to ensure that their implementation and continued operation meet the criteria and expectations on which the commitment was originally based. The basic set of trade-offs in operations, as was already mentioned, lies in the price, volume, and cost relationship, but surrounding this simple concept is an extensive array of complex choices and decisions. To begin with, the company must develop its product and service offerings to achieve excellence relative to market expectations. This must be accompanied by positioning its operations competitively to make use of its core competencies and to differentiate itself from its competitors. Here we’re talking not only about a strategic concept, but about a very practical operational application of such advantages as cost-effective facilities, superior skills and systems in delivery and customer service, highly effective information systems linked with customer networks, and unique technology or research capabilities. Deploying its resources in carefully selected target markets, the company must use appropriate pricing and service policies that are competitive in filling customers’ needs. Management must anticipate and deal with the impact of changing prices and competitors’ actions on sales volume and on the profitability of individual products or services. At the same time, all operations of the business, whether carried on inside the company or outsourced with others must not only be made cost effective, but maintained as such to achieve competitive success. Figure 2–6 highlights key elements of the operations segment of the financial system. Successful operating results also depend on a realistic understanding of the business processes employed, the economic costs and benefits of each part of the organization, and the relative contribution of products and services to overall results. This requires the use of appropriate information systems, data collection, and reporting. Part of the insight is the effect on the company’s profitability of the level and proportion of fixed (period) costs committed to the operations, versus the amount and nature of variable (direct) costs incurred in manufacturing, service, or trading operations. These concepts will be discussed in detail in Chapter 6. Sound operational planning is an essential support process. Goals and incentives are established to reinforce the need for making economic decisions. Budgeting and analysis processes are designed to give relevant feedback, and provide
hel78340_ch02.qxd
9/27/01
10:59 AM
Page 32
32
Financial Analysis: Tools and Techniques
F I G U R E 2–6
The Business System: Operations Segment Key yardsticks
Key strategies
• Operating ratios • Contribution analysis • Activity analysis • Effectiveness criteria • Benchmarking
• Product/service excellence • Competitive positioning • Core capabilities • Resource deployment • Market selection • Pricing strategy • Cost effectiveness • Operating leverage • Outsourcing; partnering
Price
Volume
Costs (fixed & Variable)
Operating profit after taxes
action signals for corrective measures should targets not be met. Enterprise modeling and activity-based accounting represent modern information structures made possible by ever more powerful computer systems and networks. We’ll discuss basic budgeting and projection of operating activity in Chapter 5, and take up the subject of modeling in Chapter 6. The key yardsticks in the operations segment include a variety of operating ratios that measure the effectiveness with which revenues and costs are managed. Among these are financial expressions such as operating profit percentages and various ratios of cost elements to sales revenue. There are overall expressions such as sales and assets per employee, and a host of operating statistics such as output per hour, yield percentages in production, or indicators of customer satisfaction with services rendered. Operating ratios vary greatly by type of business, as they have to be tailored to the specific variables that drive performance. In fact, operating ratios are ideally derived from those variables that represent key drivers for the business, whether they be physical conditions, human skills and attitudes, resource utilization, or technology application. From an economic standpoint, the relative profit and cash flow contribution margins of different products and services are important measures, not only for tracking current performance but as an input to strategic decisions about the portfolio of products and services. The distinction between accounting ratios and economic analysis is again important in the operations segment, because the answers provided by each can vary significantly. This problem has led to the wide use of a relatively recent methodology that directly addresses the need for economic answers, namely, activity-based analysis, which was mentioned earlier. This process is essentially a step-by-step identification of the physical activities involved in a specific function of the company, or the activities required to support a particular product line,
hel78340_ch02.qxd
9/27/01
10:59 AM
Page 33
CHAPTER 2 A Systems Context for Financial Management
33
followed by a careful economic analysis of the costs and benefits incurred in each step and in total. Because it amounts to an economic assessment, activitybased analysis has become an important technique for supporting the current emphasis on corporate reengineering and value-based management. In addition, benchmarking activities against best practices in the specific industry or in general business usage represents yet another popular way of refining the measures and standards to be applied. We’ll discuss a variety of key financial and economic operational criteria in Chapters 4, 5, and 6.
Financing Decisions Here we must deal with the various choices available to management for funding the investments and operations of the business over the long term. Note that the financing section begins with profit after taxes, which normally is a major source of funding for a company. Two key areas of strategy and trade-off decisions are identified: • The disposition of profits. • Shaping the company’s capital structure. Normally this set of trade-offs and decisions is made at the highest levels of management and endorsed by the board of directors of a corporation because the choices are crucial to the firm’s long-term viability. Figure 2–7 displays the relationships, yardsticks, and strategies in the financing segment. The first area, the disposition of profits, amounts to a basic three-way split of after-tax profit among: • Owners. • Lenders. • Reinvestment in the business. Every one of these choices is affected by current or past management policies, trade-offs, and decisions. For example, payment of dividends to owners is made at the discretion of the board of directors. Here, the critical trade-off choice is the relative amount of dividends to be paid out to shareholders as part of their overall return versus the alternative of retaining these funds to invest in the company’s growth, with the goal of creating additional value which will be reflected in greater share price appreciation for the shareholders. Payment of interest to lenders is a matter of contractual obligation. The level of tax-adjusted interest payments incurred (the cost to the company is the net amount after applying the corporate tax rate) relative to operating profit, however, is a direct function of management policies and actions regarding the use of debt, symbolized by the dashed line. The higher the proportion of debt in the capital structure, the greater the demand will be for profit dollars to be used as interest expense, and the greater the firm’s risk exposure will be; that is, its potential inability to meet interest obligations and/or repayment during a business downturn.
hel78340_ch02.qxd
9/27/01
10:59 AM
Page 34
34
Financial Analysis: Tools and Techniques
F I G U R E 2–7
The Business System: Financing Segment Key yardsticks • Earnings per share • Cash flow per share • Dividend payout • Interest coverage • Return on equity • Return on capitalization • Debt/equity ratio • Debt service • Cost of capital • Total shareholder return
Dividends
Operating profit after taxes
Retained earnings Shareholders' equity
Long-term debt*
Key strategies
Off balance sheet debt
• Disposition of profit: – Dividends to shareholders – Interest to lenders – Retention for reinvestment
Interest (tax-adjusted)
Funding potential
• Capital structure targets: – Types of equity capital – Types of debt capital – Off-balance sheet debt – Financial leverage – Risk/reward trade-off *Assumes a continuous rollover of debt (refinancing), that is, there is no reduction in existing debt levels from repayments, as new funds are raised to cover these, unless a policy change in debt proportions is specified. No specific provision is made here for use of off-balance sheet debt, such as operating leases.
Retained earnings represent the residual profit after taxes for the period, a net amount which remains in the company after payment of interest and dividends. This normally forms a significant part of the funding potential for additional investment and growth as shown on the bottom of the chart. We recall that the depreciation effect was added to this funding potential and reflected in the investment section, to correct for the amount of cash masked by the depreciation deduction made in arriving at operating profit after taxes, as will be discussed in Chapter 3. Additional funding potential can be found in new funds provided by lenders and investors, depending on the company’s policies governing the use of such long-term sources. Key measures in the area of earnings disposition are earnings and cash flow (after-tax profit plus the depreciation effect), calculated on a per-share basis, which are viewed as broad indicators of the company’s ability to compensate both lenders and owners. In addition, specific ratios are used that measure the proportion of dividends paid out, the degree to which earnings cover the current interest on debt, and how well total debt service requirements are covered. These measures are discussed in Chapter 4. The second area, the planning of capital structure targets, involves selecting and balancing the relative proportions of funding obtained over time from ownership sources and long-term debt obligations. The chosen combination, after taking
hel78340_ch02.qxd
9/27/01
10:59 AM
Page 35
CHAPTER 2 A Systems Context for Financial Management
35
into account business risk and debt service requirements, is intended to support an acceptable level of overall profitability while matching the degree of risk exposure deemed appropriate by management and the board of directors. A key consideration in choosing funding methods is the impact of financial leverage (see Chapter 6). It can be defined as the prudent use of funds obtained from fixed-cost debt obligations for financing opportunities that promise potential earnings higher than the interest cost on the borrowed funds—the difference benefiting the owners of the company. Again, this process requires a series of economic trade-offs, which include weighing the rewards obtained versus the risks involved in the different alternatives open to management. As we’ll discuss in Chapter 10, numerous types of equity, ranging from straight common equity to convertible shares and preferred stocks, can be used for new ownership funding. On the other hand, existing ownership funds also can be returned through repurchase of the company’s shares in the open market, using some of the current funding potential. The latter choice has become an important aspect of capital structure management, because repurchasing stock with corporate cash flow reduces the number of shares outstanding, making each remaining share proportionately more valuable. At the same time, no dividends need be paid on the purchased shares, which can be used at a later time for purposes such as acquisitions. The trade-off is between adding value through new investment and adding share value through a reduced number of shares. The choices among debt instruments are even more varied, as we’ll discuss in Chapter 10. These include operating leases and similar long-term obligations, which are called off-balance sheet debt because they are not listed on the balance sheet and only impact the income statement as annual expenses. Major measures in the area of capital structure strategy include ratios that measure the return on equity and the return on capitalization (equity and long-term debt combined), various debt service coverage ratios (Chapter 4), ratios for relative levels of debt and equity (Chapter 6), measures of the cost of various forms of capital as well as the combined cost of capital for the company as a whole (Chapters 9 and 10), and finally, shareholder value creation concepts, such as total shareholder return, economic value added, and so forth (Chapters 11 and 12). As we’ll see, one of the fundamental principles of running a successful business system is that the returns from the investments supported by the capital structure must exceed the combined cost of the equity and debt capital employed, in order to create shareholder value and a satisfactory total shareholder return. Returns just matching the cost of capital will leave value unchanged, while returns below the cost of capital will destroy value. As we’ll discuss in Chapter 12, the analyst again must distinguish carefully between accounting-based and cash flow–based measures in this area. The footnote to Figure 2–7 refers to an assumption about continuous rollover of debt. This is necessary because the business system as described here is a simple growth model with stable capital structure policies, also called target proportions. Normally, as the amount of shareholders’ equity grows with incremental retained earnings, management will likely wish to match this increase, in
hel78340_ch02.qxd
9/27/01
10:59 AM
Page 36
36
Financial Analysis: Tools and Techniques
the proper proportion, with an incremental amount of new debt—unless management decides that a change in debt policy is appropriate for a variety of reasons. In that case, specific assumptions will have to be made about the pattern of repayments planned, which, of course, will change the relative proportions of debt and equity outstanding, and also change the cash flow patterns in the model.
Interrelationship of Strategy and Value Creation
For Example
AM FL Y
It should be obvious by now that our concept of the basic business system (Figure 2–4) forces us to recognize and deal with the many dynamic interrelationships of key management strategies, policies, and decisions, and the major cash flows they cause. In effect, the system amounts to a basic financial growth model which illustrates the interplay of key variables in support of the ultimate goal—value creation through positive cash flows in excess of the cost of capital over time. Achieving consistency in the choices and decisions regarding these variables is critical to managing a firm’s long-term success and shareholder expectations, because only a well-tuned business system will perform in a superior fashion.
TE
It would be ineffective for a company to set aggressive growth strategies for its operations, while at the same time restricting itself to a set of rigid and conservative financial policies—especially when operating margins are narrow and funding needs sizable. Similarly, paying out a high proportion of current operating profit in the form of dividends, or repurchasing significant amounts of the company’s shares, while at the same time maintaining a restrictive debt policy would clash with an objective to hold market share in a rapidly expanding business that requires substantial funding. Under such circumstances, adequate funds for new investment simply wouldn’t be available, unless new equity was raised in the market. The company’s strategic position could be at risk, and the stock market would adversely assess future cash flow expectations, thereby lowering the valuation of the company. The basis for successful management, therefore, is to develop and maintain a consistent set of business strategies, investment objectives, operating goals, and financial policies that reinforce each other rather than conflict. They must be chosen through conscious and careful analysis of the various economic trade-offs involved, both individually and in combination. Proper measures and incentives must be employed, all reinforcing a long-term pattern of performance that will establish and reinforce positive shareholder expectations about current and future cash flows from successful existing investments and sound new investments—or from divestments of underperforming parts of the company. As we’ll demonstrate in later chapters, understanding the dynamics of business strategies and financial policies is essential, whether they involve operational cash flow management, key drivers of financial
Team-Fly®
hel78340_ch02.qxd
9/27/01
10:59 AM
Page 37
CHAPTER 2 A Systems Context for Financial Management
37
performance, investment and divestment analysis, or capital structure planning. Our simplified systems diagram has provided a way to recognize the main interrelationships in a broad context of management decisions and cash flows.
The Nature of Financial Statements To apply the insights gained from the conceptual overview of the business system, we must now look for available information that will: • Allow the manager or analyst to track the financial condition and operating results of the business. • Assist in understanding the cash flow patterns in more specific terms. In the process of financial/economic analysis, a variety of formal or informal data are normally reviewed and tested for their relevance to the specific purpose of the analysis. The most common form in which basic financial information is available publicly, unless a company is privately held, is the set of financial statements issued under guidelines of the Financial Accounting Standards Board (FASB) of the public accounting profession and governed by the U.S. Securities and Exchange Commission (SEC). Such a set of statements, prepared according to generally accepted accounting principles (GAAP), usually contains balance sheets as of given dates, income statements for given periods, and cash flow statements for the same periods. A special statement highlighting changes in owners’ equity on the balance sheet is commonly provided as well. Since financial statements are the source for a good portion of analytical efforts, we must first understand their nature, coverage, and limitations before we can use the data and observations derived from these statements for our analytical judgments. Financial statements reflect the cumulative effects of all of management’s past decisions. However, they involve considerable ambiguity. Financial statements are governed by rules that attempt to consistently and fairly account for every business transaction using the following conservative principles: • Transactions are recorded at values prevailing at the time. • Adjustments to recorded values are made only if values decline. • Revenues and costs are recognized when committed to, not when cash actually changes hands. • Periodic matching of revenues and costs is achieved via accruals, deferrals, and accounting allocations. • Allowances for negative contingencies are required in the form of estimates that reduce both profits and recorded value, usually affecting shareholders’ equity or special set-asides. These rules leave reported financial accounting results open to considerable interpretation, especially if the analyst seeks to understand a company’s economic
hel78340_ch02.qxd
9/27/01
38
10:59 AM
Page 38
Financial Analysis: Tools and Techniques
performance and to establish the basis for shareholder value results. It’s common practice among professional analysts to adjust the data reflected on financial statements for known accounting transactions which do not affect cash flows, and to make assumptions about the economic values underlying recorded asset values. We’ll discuss the most important of these adjustments in Chapters 4 and 12.
The Balance Sheet The balance sheet, prepared as of a specific date, records the categories and amounts of assets employed by the business (i.e., the resources committed) and the offsetting liabilities incurred to lenders and owners (i.e., the funds obtained). Also called the statement of financial condition or statement of financial position, it must always balance. By definition, the recorded value of the total assets invested in the business at any point in time must be matched precisely by the recorded liabilities and owners’ equity supporting these assets. Liabilities are specific obligations that represent claims against the assets of the business, ranking ahead of the owners in repayment priority. In contrast, the recorded shareholders’ equity in effect represents a residual claim of the owners on the remaining assets after all liabilities have been subtracted. The major categories of assets, or resources committed, are: • Current assets (items that turn over in the normal course of business within a relatively short period of time, such as cash, marketable securities, accounts receivable, and inventories). • Fixed assets (such as land, mineral resources, buildings, equipment, machinery, and vehicles), all of which are used over a longer time frame. • Other assets, such as deposits, patents, and various intangibles, including goodwill that arose from an acquisition. Major sources of the funds obtained are: • Current liabilities, which are obligations to vendors, tax authorities, employees, and lenders due within one year or less. • Long-term liabilities, which are a variety of debt instruments repayable beyond one year, such as bonds, loans, and mortgages. • Owners’ (shareholders’) equity, which represents the recorded net amount of funds contributed by various classes of owners of the business as well as the accumulated earnings retained in the business after payment of dividends. Balance sheets are static in that, like snapshots, they reflect conditions on the date of their preparation. They’re also cumulative because they represent the effects of all decisions and transactions that have taken place since the inception of the business and have been accounted for up to the date of preparation.
hel78340_ch02.qxd
9/27/01
10:59 AM
Page 39
CHAPTER 2 A Systems Context for Financial Management
39
As we indicated earlier, financial accounting rules require that all transactions be recorded at costs and values as incurred at the time, and retroactive adjustments to recorded values are made only under very limited circumstances. As a consequence, balance sheets (being cumulative) display assets and liabilities acquired or incurred at different times. Because the current economic value of assets can change, particularly in the case of longer-lived items (such as buildings and machinery) or basic resources (such as land and minerals), the costs stated on the balance sheet are not likely to reflect true economic values. Moreover, changes in the value of the currency in which the transactions are recorded can, over time, distort the balance sheet. Ultimately, the recorded book value of owners’ equity is affected by all of these value differentials. There generally is quite a divergence between this residual accounting value and the current economic value of the business as reflected in share prices or in valuations for acquisition. In fact, the shares of successful companies are usually traded at price levels far above their recorded book value (see Chapter 12). Finally, a number of relatively recent accounting rules require the estimation and recording of contingent liabilities arising from a variety of future obligations, such as pension and health-care costs, further introducing a series of value judgments. These are frequently shown as “other liabilities,” listed just ahead of shareholders’ equity, and, in effect, amount to a reclassification from being part of the owners’ residual claims, to a special form of long-term liability. The accounting profession’s FASB is expending a great deal of effort to resolve these and other issues affecting the meaning of the balance sheet, but only with partial success. Accounting standards continue to evolve, and a manager or analyst must be aware of the underlying issues and processes when reviewing and analyzing this statement. We’ll discuss the most important of these more specifically as we examine analytical techniques in later chapters. In our decisional context of investment, operations, and financing, the balance sheet is a cumulative listing of the impact of past investment and financing decisions, and of the net operational results from using these resources. It’s a historical record of all transactions that affected the current business over time. The net effect of operations in the form of periodic profit or loss is reflected in the changing shareholders’ equity account. Figure 2–8 is a simple conceptual picture of the balance sheet as it relates to the three areas of management decisions. Only the major categories normally found on the balance sheet are listed in Figure 2–8, which is an oversimplification. In actual practice, the analyst encounters a large variety of detailed asset, liability, and net worth accounts because balance sheets reflect the unique nature of a given company and the business sector to which it belongs. But the actual accounts always can be grouped into the basic categories listed. To provide an example of the balance sheet of a major corporation, Figure 2–9 shows the consolidated balance sheets for December 31, 1997, and December 31, 1996, of TRW Inc., as published in its 1997 annual report, but presented here
hel78340_ch02.qxd
9/27/01
10:59 AM
Page 40
40
Financial Analysis: Tools and Techniques
F I G U R E 2–8
Balance Sheet in Decisional Context Management Decision Area Investment
Operations
Financing
Assets
Balance Sheet
Liabilities and net worth
(on a given date)
Current assets
Current liabilities
plus
plus
Fixed assets
Long-term liabilities
plus
plus
Other assets
Net profit or loss
Shareholders' equity
equals
equals
Total assets
Total liabilities and net worth
without accompanying notes. (These are reproduced in Chapter 4, Figure 4–6). TRW Inc. is a global manufacturing and service company headquartered in Cleveland, Ohio. It’s strategically focused on providing products and services with a high technology or engineering content to the automotive, space and defense, and information systems markets. TRW holds leading positions in most of its market segments. Founded in 1901, the company employs about 72,500 people in 24 countries, and is ranked 146th in sales in the Fortune 500 listing for 1997. We’ll use TRW’s published financial statements as examples in Chapters 3 and 4 and demonstrate the use of analytical techniques on their data.
The Income Statement The income statement reflects the effect of management’s operating decisions on business performance and the resulting accounting profit or loss for the owners of the business over a specified period of time. The profit or loss calculated in the statement increases or decreases owners’ equity on the balance sheet. Thus, the income statement is a necessary adjunct to the balance sheet in explaining this major component of change in owners’ equity, and it provides a variety of performance assessment information. The income statement, also referred to as the operating statement, earnings statement, or profit and loss statement, displays the
hel78340_ch02.qxd
9/27/01
10:59 AM
Page 41
CHAPTER 2 A Systems Context for Financial Management
41
F I G U R E 2–9 TRW INC. AND SUBSIDIARIES Consolidated Balance Sheets December 31, 1997 and 1996 ($ millions)
1997 Assets Current assets: Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . Property, plant, and equipment at cost . . . . . . . . . . . . . . . . Less: Allowances for depreciation and amortization . . . . Total property, plant, and equipment—net . . . . . . . . . . Intangible assets: Intangibles arising from acquisitions . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total intangible assets . . . . . . . . . . . . . . . . . . . . . . . . . . Less: Accumulated amortization . . . . . . . . . . . . . . . . . . . . . Total intangible assets—net . . . . . . . . . . . . . . . . . . . . . Investments in affiliated companies . . . . . . . . . . . . . . . . . . Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Liabilities and Shareholders’ Investment Current liabilities: Short-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued compensation . . . . . . . . . . . . . . . . . . . . . . . . . . Trade accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . Other accruals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Current portion of long-term debt . . . . . . . . . . . . . . . . . . . Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . Long-term liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . Minority interests in subsidiaries . . . . . . . . . . . . . . . . . . . . . Shareholders’ investment: Serial preference stock II . . . . . . . . . . . . . . . . . . . . . . . . . Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cumulative translation adjustments . . . . . . . . . . . . . . . . . Treasury shares—cost in excess of par value . . . . . . . . . Total shareholders’ investment . . . . . . . . . . . . . . . . . . . Total liabilities and shareholders’ investment . . . . . . . . . . .
Source: Adapted from 1997 TRW Inc. annual report.
1996
$
70 1,617 573 79 96 ______ 2,435 ______ 6,074 3,453 ______ 2,621
$ 386 1,378 524 69 424 ______ 2,781 ______ 5,880 3,400 ______ 2,480
673 232 ______ 905 94 ______ 811 139 404 ______ $6,410 ______
258 31 ______ 289 78 ______ 211 51 376 ______ $5,899 ______
$ 411 338 859 846 38 99 128 ______ 2,719 ______ 788 1,117 57 105
$
52 386 781 775 39 52 72 ______ 2,157 ______ 767 458 272 56
1 78 462 1,776 (130) (563) ______ 1,624 ______ $6,410 ______
1 80 437 1,978 47 (354) ______ 2,189 ______ $5,899 ______
hel78340_ch02.qxd
9/27/01
10:59 AM
42
Page 42
Financial Analysis: Tools and Techniques
revenues recognized for a specific period, and the costs and expenses charged against these revenues, including write-offs (e.g., depreciation and amortization of various assets) and taxes. Revenues and costs involve elements such as: • Sales for cash or credit. • Purchases of goods for resale or manufacture, or cost of services provided. • General and administrative expenses. • Sales and marketing expenses. • Research and development costs. The income statement represents the best effort of the firm’s accountants to match the relevant items of revenue with the relevant items of cost and expense for the period, a process which involves accrual accounting and extensive use of allocation of prior and future revenues and costs. Among the judgmental areas involving costs are: • Recognizing the incidence of revenues received in advance or delayed in time. • Depreciation of assets being used over more periods than the current reporting period. • Cost of goods purchased or manufactured in previous periods. • Proper allocation of general expenses to a specific period. We’ll take up the more critical of these elements and choices as we apply the analysis techniques in later chapters. When viewed in our decisional context, the income statement in the center column of Figure 2–10 expands the details of the transactions and allocations that make up one of the key performance elements, profit or loss. Again, we are providing an actual example of an income statement in Figure 2–11, the consolidated statement of earnings for TRW Inc. for the years ending December 31, 1997, and December 31, 1996.
The Cash Flow Statement Because we are interested in the combined effects of investment, operating, and financing decisions, analyzing both the income statement for the period and the balance sheets at the beginning and the end of the period together provides more basic insights than either statement alone. Management decisions not only affect the profit for the period, but cause accompanying changes in most assets and liabilities, particularly in the accounts making up working capital, such as cash, receivables, inventories, and current payables. The statement that captures both the current operating results and the accompanying changes in the balance sheet is the cash flow statement, statement of cash flows, or funds flow statement. It gives us
hel78340_ch02.qxd
9/27/01
10:59 AM
Page 43
CHAPTER 2 A Systems Context for Financial Management
43
F I G U R E 2–10
Income Statement in Decisional Context Management Decision Area Investment
Operations
Financing
Assets
Balance Sheet
Liabilities and net worth
(on a given date)
Current assets
Income statement Revenues
plus
Fixed assets plus
Other assets equals
Total assets
less
Cost of sales
equals
Gross margin
less
Operating expenses Net profit or loss
equals Operating earnings/loss less
Income taxes
equals
Net profit or loss
Current liabilities plus
Long-term liabilities plus
Shareholders' equity equals
Total liabilities and net worth
a dynamic picture of the ultimate changes in cash resulting from the combined decisions made during a given period. The statement is prepared by comparing beginning and ending balance sheets and using key items of the income statement for the period, all interpreted in terms of uses and sources of cash: • • • • • • • •
Cash generated by profitable operations or drained by unprofitable results. Cash impact of changes in working capital requirements. Commitments of cash to invest in assets or to repay liabilities. Raising of cash through additional borrowing or by reducing asset investments. Cash impact of issuance of new shares or repurchase of shares. Cash impact of dividends paid. Adjustments for accounting allocations, write-offs, and other noncash elements in the income statement and the balance sheets. Net impact of the period’s cash movements on the company’s cash balance.
The cash flow statement thus offers a ready overview of the combined cash impact of all management decisions during the period. The user can judge both
hel78340_ch02.qxd
9/27/01
10:59 AM
Page 44
44
Financial Analysis: Tools and Techniques
F I G U R E 2–11 TRW INC. AND SUBSIDIARIES Statements of Earnings For the Years Ended December 31, 1997 and 1996 ($ millions)
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1997
1996
$10,831 8,826
$ 9,857 8,376
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Administrative and selling expenses . . . . . . . . . . . . . . . . . Research and development expenses . . . . . . . . . . . . . . . . Purchased in-process research and development . . . . . . . Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other expenses (income) net . . . . . . . . . . . . . . . . . . . . . . .
2,005 684 461 548 75 (3)
1,481 613 412 — 84 70
Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1,765
1,179
Earnings (loss) from continuing operations before taxes Excluding purchased R&D; special charges (’96) . . . . . . Reported earnings (loss) before income taxes . . . . . . . . Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
788 240 289
687 302 120
Earnings (loss) from continuing operations Excluding purchased R&D; special charges (’96) . . . . . . Reported earnings (loss) after income taxes . . . . . . . . . . Discontinued operations, gain on disposition, after taxes .
499 (49) —
434 182 298
Net earnings (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Preference dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$
(49) —
$
480 1
Earnings (loss) applicable to common stock . . . . . . . . . . .
$
(49)
$
479
Per share of common stock: Average number of shares outstanding (millions) Diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted net earnings (loss) per share From continuing operations Excluding purchased R&D; special charges . . . . . . . . . Reported . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . From discontinued operations . . . . . . . . . . . . . . . . . . . . .
123.7 123.7 4.03 (0.40) —
$
3.27 1.37 2.25
Diluted net earnings (loss) per share . . . . . . . . . . . . . . . . .
$ (0.40)
$
3.62
Basic net earnings (loss) per share From continuing operations Excluding purchased R&D; special charges . . . . . . . . . Reported . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . From discontinued operations . . . . . . . . . . . . . . . . . . . . .
$
4.03 (0.40) —
$
3.29 1.41 2.31
Basic net earnings (loss) per share . . . . . . . . . . . . . . . . . .
$ (0.40)
$
Book value per share (year-end) . . . . . . . . . . . . . . . . . . . . Tangible book value per share (year-end) . . . . . . . . . . . . . Other data ($ millions): Depreciation of property, plant, and equipment . . . . . . . . . Amortization of intangibles, other assets . . . . . . . . . . . . . . Capital expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Source: Adapted from 1997 TRW Inc. annual report.
$
132.8 128.7
13.19 6.58 $
480 10 549 154
3.72 17.29 15.62
$
442 10 500 148
hel78340_ch02.qxd
9/27/01
10:59 AM
Page 45
CHAPTER 2 A Systems Context for Financial Management
45
the magnitude and the relationships of these cash movements, such as the company’s ability to fund investment needs from operational results, the magnitude and appropriateness of financing changes, and disproportional movements in working capital needs. Observing the cash flow patterns can stimulate questions about the effectiveness of management strategies as well as the quality of operational decisions. The amount of detail can vary widely, depending on the nature of the business and the different types of movements emphasized. In the past, basic formats for these statements differed widely as well. In more recent times, the FASB and SEC required that all published cash flow statements follow a common format, listing uses and sources by the familiar three decision areas: investments, operations, and financing. This rule recognized the usefulness of this arrangement in understanding the dynamics of the business system, as described earlier. Figure 2–12 shows how the cash flow statement fits into our management decision context. One aspect of the cash flow statement that requires some explanation is the treatment of accounting write-offs. From a cash flow standpoint, write-offs such as depreciation and amortization merely represent bookkeeping entries that have no effect on cash. The reason is simply that the assets being amortized by these entries represent cash that was committed in past periods. Consequently, the write-off categories, insofar as they had reduced net profit, must be added back here as a positive cash flow, thus restoring the cash generated by operations to the original level before the write-off was made. The reader will recall that we recognized the cash flow implications of the depreciation effect in the earlier discussion of the business system. Handling of this adjustment will be illustrated more specifically in Chapter 3. The cash flow statement has the same inherent limitations as the balance sheet and the income statement, because it’s derived from the accounting data
F I G U R E 2–12
Cash Flow Statement in Decisional Context Management Decision Area Investment
Operations
Financing
Cash flow statement Investments
Operations
Financing
Investment (increases) in all types of assets are uses of cash; disinvestment (reductions) in all types of assets are sources of cash.
Profitable operations are a source of cash; losses drain cash from the system. Accounting write-offs or write-ups do not affect cash; their profit impact must be adjusted for.
Trade credit and new financing (increasing in liabiliites and equity) are sources of cash; repayments of liabilities, dividends, and returns of capital are uses of cash.
hel78340_ch02.qxd
9/27/01
10:59 AM
Page 46
46
Financial Analysis: Tools and Techniques
AM FL Y
contained in these statements. However, because it focuses on the changes incurred during the period, the limitations due to historical valuation are usually not significant. However, we must remember that by displaying the net change from the beginning to the end of the chosen period in each asset, liability, and ownership account reported, the statement might “bury” major individual transactions that occurred during the period and perhaps offset each other. Normally, however, material transactions of this kind (such as major investments, acquisitions, or divestitures) are noted specifically in the company’s cash flow statement. The statement therefore affords the user the most detailed picture of the impact of major events of the period. TRW’s consolidated cash flow statement for the years ended December 31, 1997, and December 31, 1996, in Figure 2–13 shows how the various elements are listed in practice. A number of adjustments based on information only internally available have been made by TRW to show more clearly the nature of cash movements during the periods covered, especially in view of the sale of some businesses in 1996, and two major acquisitions in 1997, as we’ll discuss in Chapter 3.
The Statement of Changes in Shareholders’ (Owners’) Equity
TE
The fourth financial statement commonly provided by a business is an analysis of the main changes, during a specific period, in the shareholders’ capital accounts, or net worth. We know from the earlier discussion that one of these changes is the net income or loss for the period, as displayed in the income statement. But other management decisions could have affected shareholders’ equity. For example, most corporations, including TRW, pay dividends on a quarterly basis. Such dividends are normally paid in cash, reducing both the cash balance and retained earnings, the latter being part of shareholders’ equity. Another decision might be to provide additional capital through sale of new shares of common stock, or conversely, the repurchase of shares in the open market using excess cash balances—some of which may be resold to employees under stock purchase or option plans. A third area might involve write-offs or adjustments of asset values connected with disposition of assets or with business combinations. A fourth area concerns the complex adjustments related to the exchange of foreign currencies by companies doing business internationally. The net change in owners’ equity can thus be selectively split into its major components to highlight the impact of these decisions. Figure 2–14 provides a conceptual view of this special analytical statement. Its limitations largely depend on how much the issuing company chooses to disclose beyond what’s legally required. Again TRW’s consolidated statement of changes in shareholders’ (owners’) equity for the years ended December 31, 1997, and December 31, 1996, is given as an actual example in Figure 2–15. The format used by the company displays the changes in each of the key areas involved, by type of stock, other capital, retained earnings, currency translation effects, and treasury stock (repurchased shares).
Team-Fly®
hel78340_ch02.qxd
9/27/01
10:59 AM
Page 47
CHAPTER 2 A Systems Context for Financial Management
47
F I G U R E 2–13 TRW INC. AND SUBSIDIARIES Statements of Cash Flows For the Years Ended December 31, 1997 and 1996 ($ millions)
1997 Operating Activities: Net earnings (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjustments to reconcile net earnings (loss) to net cash provided by continuing operations: Purchased in-process research and development . . . . . Depreciation and amortization . . . . . . . . . . . . . . . . . . . . . Deferred income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . Discontinued operations . . . . . . . . . . . . . . . . . . . . . . . . . Other—net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Changes in assets and liabilities, net of effects of businesses acquired or sold: Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Inventories and prepaid expenses . . . . . . . . . . . . . . . . . . Accounts payable and other accruals . . . . . . . . . . . . . . . Other—net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash provided by operating activities . . . . . . . . . . . . . . Investing Activities: Capital expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . Acquisitions, net of cash acquired . . . . . . . . . . . . . . . . . . Net proceeds from divestitures . . . . . . . . . . . . . . . . . . . . Other—net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash provided by (used in) investing activities . . . . . . . Financing Activities: Increase (decrease) in short-term debt . . . . . . . . . . . . . . Proceeds from debt in excess of 90 days . . . . . . . . . . . . Principal repayments in excess of 90 days . . . . . . . . . . . Dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Acquisition of common stock . . . . . . . . . . . . . . . . . . . . . . Other—net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash provided by (used in) financing activities . . . . . . . Effect of exchange rate changes on cash . . . . . . . . . . . . . Increase (decrease) in cash and cash equivalents . . . . . . Cash and cash equivalents at beginning of year . . . . . . . .
$
(49)
1996 $ 480
548 490 116 — 10 32 (26) (166) (1) ______
— 452 (182) (298) 23 (46) 8 298 (24) _____
954 (549) (1,270) — 2 ______
711 (500) (76) 789 34 _____
(1,817)
247
912 113 (89) (154) (247) 41 ______
(127) 51 (91) (148) (361) 51 _____
576 (29) ______ (316) 386 ______
(625) (6) _____ 327 59 _____
Cash and cash equivalents at end of year . . . . . . . . . . . . .
$______ 70
$ 386 _____
Supplemental Cash Flow Information: Interest paid (net of amount capitalized) . . . . . . . . . . . . . Income taxes paid (net of refunds) . . . . . . . . . . . . . . . . .
$
$
76 78
89 615
Source: Adapted from 1997 TRW Inc. annual report.
In this portion of the chapter, we have provided an overview of the nature and relationships of the four major financial statements as the background for analysis of the results of management decisions and their impact on funds movements. Within our decisional framework, these four statements can be combined
hel78340_ch02.qxd
9/27/01
10:59 AM
Page 48
48
Financial Analysis: Tools and Techniques
F I G U R E 2–14
Statements of Changes in Owners’ Equity in Decisional Context Management Decision Area Investment
Operations
Financing
Assets
Balance Sheet
Liabilities and net worth
(on a given date)
Current assets
Current liabilities
plus
plus
Fixed assets
Long-term liabilities
plus
Other assets
plus Statement of changes in shareholders' equity
Net profit or loss
Owners' equity (plus/minus) Profit/loss (plus/minus) Dividends (minus)
New equity (plus) Return of capital (minus) Adjustments (plus/minus)
equals
equals
Total assets
Total liabilities and net worth
to help us visualize their coverage and relationship as an integrated whole. Note that the generalized overview in Figure 2–16 displays not only what the four statements cover in terms of key information, but also how they are related, being derived from the same basic information. The dotted lines indicate the impact of any accounting write-offs. To summarize, the balance sheet describes the financial condition of a business at a point in time. It shows the cumulative effect of previous decisions and includes the profits or losses for preceding periods. The income statement matches revenues and expenses for a specific period, including write-offs and allocations. It provides more detail about the elements making up the after-tax net profit and loss that was recorded in the owners’ equity on the balance sheet. In contrast to the two previous statements, the cash flow statement is a dynamic representation in that it highlights the net changes in assets, liabilities, and ownership accounts over a specific period. It reflects the pattern of cash uses and sources that resulted from management’s decisions concerning investments, operations, and financing. The statement corrects for the fact that writeoffs and amortization of assets acquired in the past are bookkeeping entries and not cash movements. Finally, the statement of changes in owners’ equity gives more details concerning the change in ownership accounts as recorded on the beginning and ending balance sheets. Within the limitations of GAAP rules and the accountants’
hel78340_ch02.qxd
9/27/01
10:59 AM
Page 49
CHAPTER 2 A Systems Context for Financial Management
49
F I G U R E 2–15 TRW INC. AND SUBSIDIARIES Statement of Changes in Shareholders’ Investment For the Years Ended December 31, 1997 and 1996
1997 Serial Preference Stock II: Series 1: Balance at January 1 and December 31 . . . . . . . . . . . . . Series 3: Balance at January 1 and December 31 . . . . . . . . . . . . . Common Stock: Balance at January 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stock dividend . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchase of shares and other . . . . . . . . . . . . . . . . . . . . . Balance at December 31 . . . . . . . . . . . . . . . . . . . . . . . . . Other Capital: Balance at January 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sale of stock and other . . . . . . . . . . . . . . . . . . . . . . . . . . Balance at December 31 . . . . . . . . . . . . . . . . . . . . . . . . . Retained Earnings: Balance at January 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net earnings (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stock dividend and other . . . . . . . . . . . . . . . . . . . . . . . . . Dividends declared: Preference stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Common stock ($1.84 and $1.80 per share) . . . . . . . . . Balance at December 31 . . . . . . . . . . . . . . . . . . . . . . . . . . Cumulative Translation Adjustments: Balance at January 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . Translation adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . Balance at December 31 . . . . . . . . . . . . . . . . . . . . . . . . . Treasury Shares—Cost in Excess of Par Value: Balance at January 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . ESOP funding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchase of shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sold under stock options . . . . . . . . . . . . . . . . . . . . . . . . . Balance at December 31 . . . . . . . . . . . . . . . . . . . . . . . . . Total shareholders’ investment: . . . . . . . . . . . . . . . . . . . . .
1996
$
—
$
—
$
1
$
1
80 — (2) ______
40 42 (2) ______
78
80
437 25 ______ 462
398 39 ______ 437
1,978 (49) —
1,688 480 (39)
(1) (152) ______ 1,776
(1) (150) ______ 1,978
47 (177) ______ (130)
76 (29) ______ 47
(354) 2 (262) 51 ______
(31) 17 (372) 32 ______
(563) ______ $1,624 ______
(354) ______ $2,189 ______
Source: Adapted from 1997 TRW Inc. annual report.
judgments, financial statements are an effort to reflect, with reasonable consistency, all business transactions that, over time, result in a net improvement or worsening of the recorded value of owners’ equity. But as we’ll discuss in the ensuing chapters, the manager or analyst must carefully interpret their meaning, due to the implications of recorded values and their conservative bias. This requires using standard techniques as well as explicit judgments and adjustments
hel78340_ch02.qxd
9/27/01
10:59 AM
Page 50
50
Financial Analysis: Tools and Techniques
F I G U R E 2–16
Generalized Overview of Financial Statements Management Decision Area Investment
Operations
Financing
Assets
Balance Sheet
Liabilities and net worth
(on a given date)
Current assets
Income statement Revenues
plus
Cost of sales
Long-term liabilities
equals
Gross margin
less
Operating expenses
plus Statement of changes Shareholders' in shareholders' equity equity equity Shareholders'
Other assets equals
plus
less
Fixed assets plus
Current liabilities
Net profit or loss
equals Operating earnings/loss
Total assets
less
Income taxes
equals
Net profit or loss
equals
Total liabilities and net worth
Cash flow statement Investments
Operations
Financing
Investments (increases) in all types of assets are uses of cash; disinvestments (reductions) in all types of assets are sources of cash.
Profitable operations are a source of cash; losses drain cash from the system. Accounting write-offs or write-ups do not affect cash; their profit impact must be adjusted for.
Trade credit and new financing (increasing in liabiliites and equity) are sources of cash; repayments of liabilities, dividends, and returns of capital are uses of cash.
in evaluating the financial, and more importantly, the economic, performance of the business under review.
The Context of Financial Analysis Now that we’ve explored the broad background of business system dynamics and the nature of commonly available financial statements that describe performance and values from a specific, limited viewpoint, it’s useful to provide one more context that allows us to put the materials of the book into proper perspective. It will reinforce a number of the references we have made earlier to the judgmental aspects involved in financial analysis, and to the distinction between financial and economic analysis.
hel78340_ch02.qxd
9/27/01
10:59 AM
Page 51
CHAPTER 2 A Systems Context for Financial Management
51
F I G U R E 2–17
The Different Objectives of Financial/Economic Analysis Processes Financial Accounting Profit Determination • Revenue recognition • Expense recognition • Cost allocation • Profit definition Value Determination • Historical costs • Conservatism • Equity as residual value • Contingency recognition Tax Determination • Legal data requirements • Income/expense timing • Tax management issues • Statement adjustments
Investor Analysis
Managerial Economics
Financial Information
Activity Economics
• Adjustment process • Trend analysis • Profit projection • Cash flow projection
• Task analysis • Economic allocation • Contribution analysis • Trade-off determination
Comparative Data
Resource Effectiveness
• Industry analysis • Competitor analysis • Economic conditions • Adjustment areas
• Investment base • Capital investments • Capital divestments • Human resources
Market Analysis • Share price patterns • Market trends • Value drivers • Market models
Shareholder Value Creation • Cash flow patterns • Cost of capital • Investor expectations • Ongoing business value
Managers or analysts performing various kinds of financial/economic analysis normally do so with a specific purpose in mind. During the process of analysis, financial statements, special analyses, databases, and other information sources are used to derive reasonable judgments about past, current, and prospective conditions of a business and the effectiveness of its management. We must recognize that not only does the person performing the analysis and interpretation have a purpose and viewpoint, but so do the preparers and providers of the various types of data and information on which the analysis is based. For example, during our discussion of financial statements, we referred to the accounting rules and principles governing the compilation of these documents, and to the need to allow for the specific biases introduced by them. This isn’t to say that financial statements are right or wrong in an absolute sense, but rather that the information might have to be adjusted in some cases, or discarded in others, in order to suit the purpose of the analysis. Figure 2–17’s descriptive overview presents the key objectives of three major financial/economic processes as a context for understanding the differences in data generation and analytical orientation involved in each:
hel78340_ch02.qxd
9/27/01
10:59 AM
52
Page 52
Financial Analysis: Tools and Techniques
• Financial accounting. • Investor analysis. • Managerial economics. The table identifies these three as processes whose objectives differ, although they frequently have to draw on each other for information and data. We must consider the orientation and focus of these processes when information is shared between them, or exchanged for use by any one of them. Our ultimate aim is to analyze and judge business problems, company performance, and shareholder value in economic terms, which requires careful adjustment of data and analyses that often were prepared with different objectives in mind. When we speak of basic financial analysis in this book, we put more emphasis on the objectives of the left column (financial accounting) and to some extent on the middle column (investor analysis). When we refer to economic analysis, however, the focus is on the right column (managerial economics) and also on a number of the areas in the center column. Despite the obvious differences among the three areas, the majority of the available data are originated on the left, by financial accounting, while some are obtained from the right, from analytical efforts or internal databases on which managerial economics depends. In addition, databases covering the stock market and economic activity come into play in the center column. Financial accounting has three major objectives as governed by professional standards and SEC regulations: • • •
Profit determination. Value determination. Tax determination.
Profit determination focuses on recognizing when revenue is earned during a period, and how to determine the matching costs and expenses. A clear distinction must be drawn between the recording of a revenue or expense transaction, and the actual receipt or disbursement of cash, which might lag by days or months. Similarly, costs incurred in the past are allocated to current or future periods with the objective of determining a profit figure that matches only “recognized” revenue and expense elements. A similar allocation process might apply to anticipated future costs that are apportioned to current periods. These allocations have significant implications for cash flow analysis, as we’ll see in Chapter 4. Value determination rests firmly on the principle of historical costs, a conservative concept that uses only actual transaction evidence as the value criterion. When economic values of assets acquired in the past change, adjustments to values generally are made only if they decline. This is commonly done for accounts receivable that have become uncollectible, or inventories where market value has declined below cost. Increases are recognized (realized) only when assets are sold,
hel78340_ch02.qxd
9/27/01
10:59 AM
Page 53
CHAPTER 2 A Systems Context for Financial Management
53
not while they’re being held. The residual value of the business, that is, its recorded shareholders’ equity (book value), therefore might over time bear only limited resemblance to the equity’s market value (economic value). In addition, the growing emphasis on recording contingencies of all kinds in the liability section of the balance sheet introduces a negative bias in value, because only potential liabilities are established, not potential gains. Examples are long-term pension and benefit obligations, and potential liabilities arising from all types of operational, legal, and contractual issues. Generally such contingent liabilities are set-asides of shareholders’ equity, further diminishing the recorded book value of equity. Meanwhile, appreciation of assets like land, buildings, natural resources, technologies, and patents is left unrecognized until they’re disposed of. As the wave of corporate takeovers in the past fifteen years demonstrated, careful analysis of the target companies’ balance sheets often uncovered massive amounts of unrecorded potential gains, which could be turned into cash from the eventual breakup of the acquired companies, and used in part to pay for the acquisition. Tax determination is governed by the legal requirements of the current income tax code, which often requires modified principles of income and expense recognition, including disallowance of certain costs and expense—in effect amounting to a different set of books. Tax rules tend to speed up the timing of revenue recognition compared with financial accounting rules, and at the same time, delay expense recognition. These rules are clearly designed to enhance current tax receipts for the government. Differences between financial accounting for reporting purposes and for tax accounting give rise to tax management issues (legally minimizing taxes) in companies and industries where the amounts involved could be significant enough to affect actual decisions on investments, operations, and financing. From the standpoint of financial analysis, the important question is what effect tax accounting has on the financial statements used for analysis. As we’ll see, the amount of taxes actually paid versus the amount shown on the income statement can differ materially, and adjustments made on the balance sheet to compensate for this situation might involve significant funds movements. From an analytical standpoint, we’ll show the importance of recognizing the tax implications of various types of decisions in Chapters 7 through 12. Investor analysis in this context has three objectives: • Interpretation of financial information. • Use of comparative data. • Analysis of financial markets. Interpretation of financial information essentially amounts to analyzing financial statements and other financial data about a company in order to assess and project its performance and value. The key judgments focus on the adjustment process through which reported accounting data are modified or converted into information that permits economic and cash flow assessments to be made. Only
hel78340_ch02.qxd
9/27/01
10:59 AM
Page 54
54
Financial Analysis: Tools and Techniques
rarely can financial data, as generally provided, be used in their exact form to derive analytical judgments. Applying the various ratios and relationships discussed in Chapter 4, for example, often leads to significant questions and actual adjustments during the analysis. Trend analysis uses various series of adjusted past data to look for and analyze significant changes in magnitudes and ratio relationships over time, and it becomes one of the bases of profit projection. Finally, the ultimate adjustment leads to understanding the pattern of net cash flows generated by the business, and the projection of these cash flows as an indicator of expected economic performance and value. Comparative data are an essential part of financial analysis, as they help put judgments about a particular company or business in perspective. By implication, all judgments made about performance and value are relative to the standards and perceptions of the analyst; comparable data assist in confirming these judgments. Industry analysis involves the selection of relevant groupings of companies and compiling appropriate data and ratios (generally available in on-line databases) against which to measure the attributes of the company being studied. The important issue here again is the need to interpret and adjust the financial data so that they match the data used for the original company. Competitor analysis applies the same process to individual companies or divisions of those companies that compete directly with the business. Economic conditions and the competitive dynamics of the markets served are brought into the analysis as a backdrop for explaining past variations, and as a guide to projecting future performance and value. Market analysis involves the study and projection of the pattern of share prices of the company and its competitors relative to trends in the stock market, in relation to general economic and political conditions, and with reference to industry and company-specific forces. It is here that financial analysis becomes a bridge between published financial statements and stock market trends that reflect the economic value of a company. The analyst focuses on the value drivers behind the market value of the shares, which are basic economic variables like cash flow generated and the relative cost effectiveness of the business, along with judgments about the expected impact of known strategies in the competitive setting. Market models range from simple relationships of key variables and share price to complex computer simulations, in an effort to determine the current and potential shareholder value created by the expected cash flows of the business. Managerial economics encompasses three basic objectives: • Determining activity economics. • Determining resource effectiveness. • Creating shareholder value. All three areas deal with economic insights management can use to make decisions that will enhance shareholder value. In that sense, the orientation of managerial economics is closely allied to the basic purpose of economic analysis as we define it here. In fact, the third objective directly supports the ultimate ques-
hel78340_ch02.qxd
9/27/01
10:59 AM
Page 55
CHAPTER 2 A Systems Context for Financial Management
55
tion: Is the business creating value for its owners? In later chapters, we’ll address the most important aspects of these areas. Activity economics is a summary term for various types of processes and analyses that define and establish economically relevant data to describe and judge the relative attractiveness of any operational aspect of a business and its subdivisions. Among these, task analysis amounts to determining the true economic cost of a task, whether it be a functional area like purchasing, or legal services, or a line area like selling. This is done by identifying and measuring the series of steps required to provide a service, or the phases of a manufacturing process, and to establish the resources used directly or indirectly in each case. This kind of analytical process, referred to previously as activity-based accounting, goes far beyond cost accounting principles. These principles often fall short of a proper economic allocation of jointly used resources or often they can’t recognize all aspects of a task or an activity. Contribution analysis refers to measuring the difference between revenues created and the economic costs involved in a given line of business or a particular product or service. Such information on economic contribution helps management plan which combination of activities will create the most economic value over time. The choices always require economic trade-offs based on economic data, not accounting information. By using activity-based accounting information, management can make both operational and strategic choices in monitoring and adjusting its portfolio of products and services. Resource effectiveness addresses the important question of how well, from an economic standpoint, the resources employed by a business are currently being utilized or will be utilized in the future. The process includes measuring the returns from the existing investment base, gauging the economic justification of new capital investments or capital divestments, and measuring the returns from human resources. These questions will be discussed in more detail in Chapters 3, 7, and 8 where again we’ll highlight the need to develop an economic basis for these judgments. Shareholder value creation, management’s ultimate goal, is measured by means of a combination of past and projected cash flow patterns, the cost of capital of the particular company, and the overall return expectations of investors for this type of business. In essence, shareholder value creation becomes a tangible expression of the risk/reward trade-off the investor has to judge when investing in the equity of a company. Management has to assess at all times whether cash flow expectations from the strategies, policies, and decisions employed are likely to serve the investors’ interest by creating additional shareholder value. The approach will be discussed in detail in Chapters 8, 11, and 12.
Key Issues The following is a recap of the key issues raised directly or indirectly in this chapter. They are enumerated here to help the reader keep the materials discussed within the perspective of financial theory and business practice.
hel78340_ch02.qxd
9/27/01
10:59 AM
Page 56
56
Financial Analysis: Tools and Techniques
TE
AM FL Y
1. Managing a business successfully requires an understanding of the systematic relationships among the key elements in the areas of investment, operations, and financing, and the impact of decisions on these relationships. Total systems thinking is a critical requirement both in setting strategies and in their execution. 2. Cash flow is the ultimate driver of business performance and value, but its use in internal and external analysis generally requires considerable care in selecting data, constructing proper analytical frameworks, and interpreting the results. 3. Expectations by shareholders about future cash flows are the basis for deriving shareholder value. The value of a business relative to its peers and the stock market as a whole will change with these expectations. This requires a future orientation in analyzing business performance. 4. Creating shareholder value is a key responsibility of business management, the success of which depends on consistent use of sound economic trade-offs in all decisions made by the management team. This requires an understanding of the cash flow implications of decisions, and an organizational climate and incentives that will foster such consistency in strategies, policies, and in making and implementing management decisions. 5. While published financial statements are the most widely available source for financial analysis, the limitations inherent in their preparation (based on generally accepted accounting principles) require a basic understanding on the part of the user of how analytical results in the areas of performance and valuation can be distorted and what adjustments might be necessary. 6. The context of any analytical effort is critical to successfully addressing the issue or problem to be resolved by the analysis. Much of the thought process underlying an analysis should be directed to ensuring consistency between the objectives and the data sources and processes employed.
Summary First, we provided a conceptual overview of the business system to show the dynamic interrelationship of cash flows activated by management decisions. Three basic decision areas were recognized—investment, operations, and financing— that underlie all business activity. The cash impact of decisions in any or all of these areas on the system was shown. The systems view also demonstrated how decisions in each area were affected by key strategies and policies, and how consistency was essential in optimizing the system to achieve the ultimate goal—enhanced shareholder value. The overview also provided a first look at major areas of financial and economic analysis, and how these were related to management strategies and decisions.
Team-Fly®
hel78340_ch02.qxd
9/27/01
10:59 AM
Page 57
CHAPTER 2 A Systems Context for Financial Management
57
Second, we gave an overview of the major financial statements commonly prepared by companies, and their relationship both to each other and to the three decisional areas defined earlier. We also indicated how the origin, rationale, and limitations of financial statements affect the potential for analyzing performance and value, and how important the cash flow statement is as a useful dynamic view of the changing cash flow patterns in the system. Third, we established the context within which most financial analysis takes place, and provided an overview of the various objectives of analysis and data preparation. This was done to highlight the need for building a bridge between accounting-oriented data and the ultimate objective of financial/economic analysis, that is, judging business performance and shareholder value creation in economic terms. Adjustment areas were suggested as prerequisites for developing useful information, and the analyst’s judgmental role was emphasized. The chapter served as a contextual preview of the various analytical concepts explored in the remainder of the book. Its intent was to reinforce the point that financial/economic analysis is not a freestanding activity or an end in itself, but rather an effort to understand and judge the characteristics and economic performance of a highly interrelated system of financial relationships.
Analytical Support Financial Genome, the commercially available financial analysis and planning software described in Appendix I, is accompanied by an interactive template (TFA Template under “extras”), representing the business system diagram in Figure 2–4 on page 28. The template allows the user to vary the key assumptions about the investments, operations, and financing conditions of a sample company, and to observe the changes resulting from these modifications on the graphic representation of the business system. The template also contains a set of abbreviated financial statements linked to the systems diagram, displaying the results of the changes made. Moreover, the major positive and negative cash flow movements are highlighted on an active bar graph. The template helps the user explore and understand in depth the linkages within the system and its accompanying financial statements, and to simulate and test the impact of any one, or a combination of, modifications in financial policies, investment commitments, and price/volume/cost conditions. (see ”Downloads Available” on p. 431)
Selected References Copeland, Tom; Tim Koller; and Jack Murrin. Valuation: Measuring and Managing the Value of Companies. New York: John Wiley & Sons, 1990. Johnson, H. Thomas, and Robert S. Kaplan. Relevance Lost: The Rise and Fall of Management Accounting. Boston: Harvard Business School Press, 1987. Kaplan, Robert S., and David P. Norton. The Balanced Scorecard. Boston: Harvard Business School Press, 1996.
hel78340_ch02.qxd
58
9/27/01
10:59 AM
Page 58
Financial Analysis: Tools and Techniques
Knight, James A. Value Based Management: Developing a Systematic Approach to Creating Shareholder Value. Burr Ridge, IL: Irwin/McGraw-Hill, 1998. Martin, John D., and J. William Petty, Value Based Management. New York: The Financial Management Association Survey and Synthesis Series, 2000. McTaggart, James M.; Peter W. Kontes; and Michael C. Mankins. The Value Imperative: Managing for Superior Shareholder Returns. New York: Free Press, 1994. Porter, Michael E. Competitive Advantage: Creating and Sustaining Superior Performance. New York: Free Press, 1985. Rappaport, Alfred. Creating Shareholder Value. New York: Free Press, 1997. Stewart, B. Bennett. The Quest for Value. New York: Harper Business, 1991.
hel78340_ch03.qxd
9/27/01
11:00 AM
Page 59
CHAPTER 3
MANAGING OPERATING FUNDS
W
e now turn to the key issues surrounding the flow of funds through a business, that is, how to properly manage, on an ongoing basis, cash inflows and funding requirements for day-to-day operations. Managers must understand the specific cash movements within the business system, which are caused by their daily decisions on investment, operations, financing, and the many external circumstances affecting the business. These decisions and events, in one form or another, affect the company’s ability to pay its bills, obtain credit from suppliers and lenders, extend credit to its customers, and maintain a level of operations that matches the demand for the company’s products or services, supported by appropriate investments. In the end, the combined effect of these decisions is the creation of shareholder value—but, as we’ve stated before, only if the net cash flows achieved by the business exceed the market’s expectations over time. It should be obvious by now that every decision has a monetary impact on the ongoing pattern of uses and sources of cash. Management’s job is to maintain at all times an appropriate balance between cash inflows and outflows, and to plan for the cash impact of any changes in operations—whether caused by management’s decisions or by outside influences—that might affect these flows. Properly managing operating cash flows is, therefore, fundamental to successful business performance. The principle is quite simple: Obtain the most performance over time with the least commitment of resources. In practice, however, leads and lags in receipts and payments, unexpected deviations from planned conditions, delays in receiving cash from funding sources, and myriad other factors can make cash flow management a complex challenge. New businesses often find that balancing operating funds needs and sources is a continuous struggle for survival. Yet, even wellestablished companies need to devote considerable management time and effort to balance the ongoing funding of their operations as they strive for optimal economic results. 59
Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
hel78340_ch03.qxd
8/6/01
60
3:31 PM
Page 60
Financial Analysis: Tools and Techniques
In addition to managing working capital, balancing operating funds flows requires dealing with the changing cash flow patterns of periodic profits and losses, and with the ultimate cash impact of current decisions on both new investment and new financing choices. As we’ll demonstrate, managing operating funds requires a thorough understanding of the combined systems effect of investment, operating, and financing decisions. This includes recognizing the impact on funds uses and sources caused by various basic operating conditions, such as seasonal peaks and valleys, cyclical variations, rapid growth, or gradual decline. In every circumstance the resulting cash flow patterns will behave in very different ways, and will put stresses on the financial system at different points and in different time frames. For Example Managing working capital soundly is a major Current Current operating cash flow challenge. The key liabilities assets components of working capital, accounts receivable, inventories, and accounts payable Longoften represent significant funds commitments Working term capital and sources for a business. In fact, the basic debt level of working capital (commonly defined Fixed as the difference between current assets and assets current liabilities) with which a business Shareoperates represents a long-term investment holders' equity supported by long-term capital sources. Each Other component, however, must be carefully assets managed to match the changing requirements of operations—with the objective of minimizing the resources committed at any point in time while meeting all operational needs, such as ensuring smooth production and customer service goals. Management should plan for fluctuations in working capital as a result of changing conditions, rather than be surprised by soaring inventories or overextended supplier credit. As in all business decisions, economic trade-offs apply here: Is the cost of carrying extra inventory outweighed by better service to customers? Is the cost of granting higher discounts for early payment offset by the reduction in receivables likely to be outstanding? What is the real cost of not meeting the credit terms extended by the company’s vendors? In Chapter 4, we’ll examine a variety of performance measures drawn from financial statements, which we know to be periodic summaries of financial condition and operating results. As we’ll see, these summaries often mask peaks and valleys of funds movements—for example, a seasonal buildup causing critical near-term financing needs—because these points mights lie within the period spanned by the statements. Obviously, managing a business is an
hel78340_ch03.qxd
9/27/01
11:00 AM
Page 61
CHAPTER 3 Managing Operating Funds
61
ongoing day-to-day process, which must deal with peaks and valleys of cash flows as they occur. In this chapter, we’ll describe how operating funds cycle through a business, what the implications of these movements are, and how to identify the critical financial variables that must be weighed in making daily operating decisions. We’ll demonstrate how significantly different types of operations impact a company’s cash flow pattern, and also highlight key accounting issues, such as inventory costing and methods of depreciation. Then we’ll return to the interpretation of cash flow statements, using our sample of TRW’s 1997 and 1996 financial data, and demonstrate how to use cash flow statements in a meaningful way. Finally, we’ll discuss the key levers available to managers with which to minimize funds needs, moderate the impact of fluctuations, and generally optimize the management of operating funds as part of shareholder value creation.
Funds Flow Cycles Businesses vary widely in orientation, size, structure, and products or services, but they all experience operating funds cycles that eventually affect cash needs and availability. To illustrate the simplest of circumstances, let’s observe a solitary ice cream vendor who sells cones from his cart for cash. To carry on this business, he has to provide an inventory on wheels, which he slowly converts into cash as the day progresses. Let’s also assume that he has invested his own cash at the beginning of the day to purchase the ice cream from his supplier. He obviously hopes to recoup these funds as well as pocket a profit by the end of the day. Our vendor’s decision to commit his own cash to inventory can be visualized in Figure 3–1, which traces the funds movements in a simple diagram. Note that the layout reflects the three decision areas we discussed in Chapter 2. F I G U R E 3–1
Ice Cream Vendor Initial Cash Investment to Start the Day
Management Decision Context Investment
Operations
Financing
Cash
Ice cream inventory
Owner's equity
hel78340_ch03.qxd
9/27/01
11:00 AM
Page 62
62
Financial Analysis: Tools and Techniques
The initial cash investment is financed from the owners’ equity, and in turn, the cash is used to invest in the first day’s inventory. If our vendor was short of cash, he could sign an IOU for the supplier, promising to pay for the inventory the next morning, using the day’s cash receipts as funding. This assumption modifies the diagram, as shown in Figure 3–2. Here, the creditor’s funds effectively supplant the owner’s funds, if only for a single day. F I G U R E 3–2
Ice Cream Vendor Initial Use of Credit to Start the Day
Management Decision Context Investment
Operations
Financing
Cash
I. O. U. to supplier
Ice cream inventory
Owner's equity
In any event, our vendor’s funds cycle is very short. The initial investment in inventory, funded either with his own cash or with credit from his supplier, is followed by numerous individual cash sales during the day. These receipts build up his cash balance for the following day’s operations. Next, we’ve represented the first day of operations—assuming the vendor financed the inventory himself—in Figure 3–3, where cash on hand is built up by sales receipts, inventory is drawn down during the day, and the difference between sales revenue and the cost of the ice cream sold represents the profit earned. This profit increases ownership equity, reflecting the value created during the day. The following morning, our vendor uses the accumulated cash either to replenish his inventory, or to pay off the supplier so that he’ll be extended credit for another day’s cycle. Any profit he has earned above the cost of the goods sold will, of course, be his to keep, or to invest in more inventory for the next day. Figure 3–4 shows the alternative funds movements that would arise had our vendor used supplier credit for the first day. He would find that the amount of cash left after repayment of the initial supplier credit—the amount of his profit for the first day—would purchase only a portion of the next day’s inventory. To continue operating on the second day he would have to decide whether to • •
Ask for renewed credit from his supplier, or Provide the additional funds from any resources of his own that aren’t yet committed to the business.
hel78340_ch03.qxd
9/27/01
11:00 AM
Page 63
CHAPTER 3 Managing Operating Funds
63
F I G U R E 3–3
Ice Cream Vendor Profitable Operations during the First Day
Management Decision Context Investment
Operations
Cash sales
Cash on hand
Financing
Supplier credit
less
Ice cream inventory
Cost of goods sold
Owner's equity
Profit for the day
F I G U R E 3–4
Ice Cream Vendor Repayment of Credit after Profitable First Day
Management Decision Context Investment
Operations
Financing
Cash on hand
Cash sales
Supplier credit
less
Ice cream inventory
Cost of goods sold
Profit for the day
Owner's equity
hel78340_ch03.qxd
9/27/01
11:00 AM
Page 64
64
Financial Analysis: Tools and Techniques
Funds cycles of larger and more structured businesses differ from this simple situation only in complexity, not in concept. Even for the most complex international conglomerate, the ultimate form of settlement of any transaction is cash. However, such a company’s operational funds cycle usually involves a variety of partially offsetting credit extensions, changes in inventories, transformations of assets, etc., that precede the cash collections or payments. In essence, any funds cycle arises because of a series of lags in the timing of business transactions. Our ice cream vendor has a lag of only a few hours between the purchase of his inventory and its conversion into cash through many small transactions. In contrast, a large manufacturer might have a lag of months between the time a product is made in the factory and the ultimate collection of the selling price from customers who purchased on trade credit. A service company might have a lag of weeks between the time salaried or contract professionals are paid for their work and the ultimate collection of service fees. Management must plan for and find the financing for company funds which are tied up because of these timing lags. This is important because these funds will remain committed for the foreseeable future, unless there are significant changes in the company’s operations. As with any type of investment, management should attempt to minimize this resource commitment while maintaining operational effectiveness. Ways to reduce the funding required include methods such as “justin-time” delivery of materials or parts in manufacturing, or purchasing merchandise on consignment in retailing. To illustrate the nature of the concept further, we’ll further explore the following three processes: • • •
The funds cycle of a simplified manufacturing operation. The funds cycle for selling the manufactured products. The funds cycle for a service organization.
We’ve separated these processes for purposes of illustration and discussion, even though the first two cycles are always intertwined in any ongoing business that both produces and sells products. The sales cycle alone, of course, applies to any retail, wholesale, or trading operation that purchases goods for resale, while the service cycle amounts to a modification of the sales cycle.
The Funds Cycle for Manufacturing To keep the illustration simple, let’s assume that the Widget Manufacturing Company has just begun operations and is going to produce widgets for eventual sale. Figure 3–5 shows the company’s funds flow cycle in the form of an overview, using minimal detail. We’ve again arranged the diagram to reflect the three management decision areas. As is readily apparent, the company was initially financed through a combination of owners’ equity, long-term debt, and three kinds of short-term debt:
hel78340_ch03.qxd
9/27/01
11:00 AM
Page 65
CHAPTER 3 Managing Operating Funds
65
F I G U R E 3–5
Funds Flow Cycle for Manufacturing Management Decision Context Investment
Operations
Cash
Wages Expenses
Raw materials inventory
Materials Supplies
Finished goods inventory
Salable products
• • •
Financing
Expenses
Production transformation
Accounts payable
Short-term liabilities
Other current liabilities
Fixed assets
Write-off Depreciation
Long-term liabilities
Other assets
Write-off Amortization
Shareholders’ equity
Accounts payable due vendors of materials and supplies. Some short-term loans from banks. Other current liabilities, such as accrued wages and taxes.
The initial investments involve fixed assets (such as plant facilities), other assets (such as patents and licenses), and three kinds of current assets: •
Cash.
•
Raw materials inventory. Finished goods inventory.
•
Of course, the last of these won’t appear until the plant actually starts producing widgets. We can assume that long-term debt and owners’ equity are the logical sources of funds for investing in plant and equipment, because they match the long-term funding commitment involved. In contrast, the short-term loans most likely provided the ready cash needed to start operations. Materials and supplies were bought with short-term trade credit extended by the company’s vendors.
hel78340_ch03.qxd
9/27/01
11:00 AM
Page 66
66
Financial Analysis: Tools and Techniques
TE
AM FL Y
As production begins, a basic transformation process takes place. Some of the available cash is used to pay weekly wages and various ongoing expenses. Materials and supplies are withdrawn from inventory and are used in manufacturing widgets. Inventories are replenished with additional credit. Some operating inputs, like power and fuel oil, are obtained on credit, and are temporarily financed through accounts payable. Use of the plant and equipment is reflected in the form of a depreciation charge, which becomes part of the cost of the transformation process. Any patents and licenses are similarly amortized and charged to the production cost. As widgets are finished on the factory floor, they’re moved into the warehouse and their cost is added to the growing finished goods inventory account. In the absence of any widget sales, the production process continuously transforms cash, raw materials, expense accruals, and trade credit into a growing buildup of finished goods inventory. A fraction of the original cost of the building, machinery, and other depreciable assets used has now become part of the cost of finished goods via the depreciation charge—even though no cash is actually moved by this allocation process. This accounting write-off merely affects the company’s books by transferring a portion of the recorded cost of the assets into the cost of the inventory. Remember, the only time cash actually changed hands was when the assets were originally acquired. What are the funds implications of this transformation? The operational funds flows, which occurred after the business was established, so far had affected only working capital components. The major sources of funding for the production process largely came from drawing down cash and raw materials, which were among the initial funds committed. An additional source was found in increased trade credit and in expenses accrued but not yet paid. The major use of these funds was in the buildup of finished goods inventory. Unless the company can eventually turn finished goods into cash through successful sales to its customers, the continued inventory buildup will eventually drain both the cash reserves and the stores of raw material. These will have to be replenished by new infusions of credit or owners’ equity, or both. Adding to the cash drain is the obligation to begin the repayment— on normal terms such as 30 or 45 days from the invoice date—of accounts payable for trade credit incurred. From a funds flow standpoint, several timing lags are significant in our example: •
•
•
A supply of raw materials sufficient for several days of operation has to be kept on hand to ensure uninterrupted manufacturing, assuming that just-in-time delivery arrangements are not possible. The physical lag in the number of days required to produce a widget causes a buildup of an inventory of work in process, that is, widgets in various stages of completion. A sufficient number of widgets must be produced and kept at all times in finished goods inventory to support an ongoing sales and service effort.
Team-Fly®
hel78340_ch03.qxd
9/27/01
11:00 AM
Page 67
CHAPTER 3 Managing Operating Funds
67
The combined funds commitment caused by these lags has to be financed on a continuous basis through resources provided by owners and creditors, as long as the pattern of lags remains unchanged. Offsetting this funding requirement, but only in part, is the length of time over which credit is extended by the company’s suppliers. This is a favorable lag because purchases of raw material and supplies, as well as certain other expenses, will be financed by vendors as accounts payable for 30 or 45 days, or for whatever length of time is common usage in the industry. New credit will continue to be extended as repayments are made of the accounts coming due. Another significant favorable lag is the temporary funding provided by the employees of the company whose wages are paid periodically. In effect, employees are extending credit to their employer for a week, two weeks, or even a month, depending on the company’s payroll pattern. Such funding is recognized among current liabilities as accrued wages. Other expense accruals, such as income taxes currently owed, will provide temporary funds as well. As we observed before, however, the buildup of finished goods in the warehouse cannot go on indefinitely, and at some point, revenues from the sale of the widgets become essential to replenishing cash in order to meet the company’s obligations as accounts become due. To complete the picture, we must examine the funds implications of the selling process.
The Funds Cycle for Sales The funds flows caused by selling the widgets can be examined within our decisional framework, as shown in Figure 3–6. The operations segment in the center of the diagram now includes the main elements of an income statement: • • • • •
Sales revenue. Cost of goods sold. Selling expenses. General and administrative expenses. Net income.
The selling cycle is based on a major timing lag, which arises from the extension of credit to the company’s customers. If the widgets were sold for cash, collection would, of course, be instantaneous. If the company provides normal trade credit, however, the collection of accounts receivable will be delayed by the terms extended to customers, such as 30 or 45 days, depending on prevailing practice in the business sector. This sales lag, like the lags incurred during the production cycle, has to be financed continuously, because for any given volume of sales, the equivalent of 30, 40, or 50 days’ worth of sales will always be outstanding. As accounts becoming due are collected, new credit will be extended to customers on current sales—as was the case with the vendors supplying materials and other items to the company itself.
hel78340_ch03.qxd
9/27/01
11:00 AM
Page 68
68
Financial Analysis: Tools and Techniques
F I G U R E 3–6
Funds Flow Cycle for Sales Management Decision Context Investment
Operations
Financing
Expenses Cash
Accounts payable
Accounts receivable
Sales
Short-term liabilities
Inventories
Cost of sales
Other current liabilities
Fixed assets
Operating expenses
Long-term liabilities
Net income
Shareholders’ equity
Write-offs Other assets
Cost of goods sold represents the value of the widgets withdrawn from finished goods inventory, each of which contains a share of the labor, raw material, and overhead. Other costs expended in its manufacture include apportioned depreciation for the use of the facilities and a share of the amortization of any patents or licenses involved. Selling expenses, which consist of the salaries of the sales force, the marketing support staff, and advertising and promotional costs, will be paid partly in cash and partly with funds obtained from creditors. General and administrative expenses will be paid in a similar fashion. Once all these costs and expenses have been subtracted from sales revenue, the resulting net income (or loss), after allowing for state and federal income taxes, causes an increase (or decrease) in owners’ equity. What are the funds flow implications of this picture? First of all, assuming that the company is maintaining a level volume of sales and manufacturing operations, management must plan for a continuous long-term commitment of funds to support the necessary amount of working capital. This means that sufficient funds must be provided to carry inventories of raw materials and work in process
hel78340_ch03.qxd
9/27/01
11:00 AM
Page 69
CHAPTER 3 Managing Operating Funds
69
in support of production. In addition, funds are needed to maintain a proper level of finished goods to support smooth sales and deliveries, and to allow for sufficient accounts receivable balances outstanding to permit normal credit extension to customers. Also, a minimum cash balance must be maintained for punctual payment of currently due obligations. Beyond these working capital requirements, additional funds are likely to be needed for any investment outlays on fixed and other assets that support growing operations. Finally, arrangements have to be made for payment of declared dividends, any scheduled repayment of debt, or for refinancing long-term obligations. The sources of this financing will be derived only in relatively small part from outstanding accounts payable, which can usually support a portion of raw materials, supplies, and ongoing operating expenses in line with the normal number of days’ credit extended by the suppliers. The difference between the amount of funds continually tied up in inventories and receivables, and the funds provided by current accounts payable, must come from sources that are relatively permanent, such as long-term debt and owners’ equity—the latter augmented by aftertax profits or diminished by net losses. The dynamics of the system are such that once desired conditions and relationships have been reached, the requirement for operating funds will be constant as long as the business operates on a sustained level. As we shall see in the section on the variability of funds flows, however, the level of funding requirements will change significantly when operational conditions themselves change.
The Funds Cycle for Services The funds flows characterizing a service organization are similar to the sales cycle we just discussed. Service businesses for the most part do not produce any physical goods, but instead make available a wide range of activities to their customers. These include providing information and advisory services, electronic communication, equipment servicing, physical or electronic delivery, retailing or wholesaling functions, transportation services, temporary staffing, data processing, and so on. Services, whether based on contractual arrangements, trade credit, or cash remittances, will produce periodic cash inflows to the provider, with normal lags in collection matching the service pattern. While certain service businesses require extensive physical infrastructure resources, such as stores and warehouse facilities, delivery fleets, diagnostic and repair equipment, or data processing networks, the funds flow cycle tends to be centered more on working capital elements and their leads and lags. Infrastructure resources are frequently obtained through leasing arrangements, which effectively transform their funding into periodic cash payments. Human resources are a significant portion of the funds flow mix, again representing near-term cash requirements. Thus the funds flow implications are largely the interplay of payment for current expenses, current infrastructure support, and collection of services billed. Inventories have a significant role in manufacturing but are minor elements in
hel78340_ch03.qxd
9/27/01
11:00 AM
70
Page 70
Financial Analysis: Tools and Techniques
many service businesses. There they are limited to supplies or parts used in carrying out service activities—except in the case of retailing and wholesaling operations, where they are a critical part of the funds picture. The funds flow cycle pattern of Figure 3–6 applies to service businesses with minor modifications, the main differences being the relative importance of working capital elements and the relative impact of infrastructure elements represented by fixed assets. As in the case of the sales cycle, basic working capital needs will require permanent funding, and the interplay of sales, cost of services (or goods) sold, and attendant support expenses will result in operational cash inflows. Increased infrastructure needs will have to be funded over time through leasing or ownership. Major marketing or new service initiatives also will require funding from the normal mix of profit, the depreciation effect, and long-term sources. Under stable conditions, operational cash flow patterns for service businesses will level out, given an integrated set of operational and financial policies. But stable conditions are the exception rather than the rule, and we now turn to the implications of changing conditions.
Variability of Funds Flows Unless there are significant changes in a company’s internal conditions or in its markets, the level of ongoing financing needed to support operations will mainly depend on effective inventory management, sound management of customer credit, and prudent use of supplier credit, as well as reliable relations with other lenders, such as banks. Also, cost-effective and profitable operations will generate cash that can be used as part of the funding pattern. The company’s continuous funding needs will, of course, be increased if collections from customers worsen, credit terms extended by suppliers or lenders tighten, or profits decline. Rarely does a company enjoy the steady-state conditions that made financing so predictable in our simple illustrations. In reality, several internal and external factors can affect any business. Major internal forces include management’s ability to seize growth opportunities, its effectiveness in managing all activities, or its inability to stem a decline in the company’s volume of operations. Major external forces include the competitive interplay in the industry, as well as seasonal variations and cyclical movements in the economy, which go beyond the impact of specific actions taken by the company’s competitors. Each of these conditions has its own particular cash flow implications, and we’ll illustrate the most important of these now.
Growth/Decline Variations Growth A pattern of steady growth in a business brings with it the need to fund the underlying expansion of all financial requirements. Successful growth can’t be
hel78340_ch03.qxd
9/27/01
11:00 AM
Page 71
CHAPTER 3 Managing Operating Funds
71
achieved without providing for appropriate increases in working capital, longterm investments, and other expenditures. These growing funds commitments will be permanently tied up as long as growth continues or as long as operations remain at a given level. Normal profits earned from successful operations usually supply only a portion of these funding needs. Consider the following rules of thumb: •
•
•
If the business sells on 30-day credit, the value of each incremental layer of sales will be added to accounts receivable for 30 days and must be funded continually, because as prior sales are collected, new and larger current sales are added. Similarly, if the business turns over its inventory nine times per year, the value of the incremental cost of the goods sold will have to be added to inventories in the form of 40 days’ worth of inventory (360 9), which must also be funded continually. Offsetting this additional use of funds, but only in part, will be the incremental growth in accounts payable and other minor accruals. The credit from the company’s vendors will amount to an equivalent value of the additional purchases for, say, 30 days, if that is the usual credit pattern.
For Example Let’s take the simple example of a wholesaling company, which sells on terms of 45 days, buys on terms of 40 days, and turns over its inventory every 30 days (twelve times per year). Cost of goods sold is 72 percent of sales, and profit after taxes 6 percent. As the company grows, funding needs for every incremental $100 in annual sales will be: • Accounts receivable increase by $12.50 ($100 45/360). • Inventories of goods purchased increase by $6.00 ($72 30/360). • Accounts payable to vendors increase by $8.00 ($72 40/360). The net effect is a funding requirement of $10.50 in additional working capital ($12.50 $6.00 $8.00), assuming no other changes take place in the company’s financial system. At the normal level of after-tax profits of 6 percent, the company could provide only $6.00 of the funding needed— that is, if no other uses of these profits existed, such as paying dividends to shareholders, or expanding the warehouse and associated equipment to support the growth trend. Thus, a minimum of $4.50 would have to be continuously financed for every $100 in additional sales generated.
hel78340_ch03.qxd
9/27/01
11:00 AM
Page 72
72
Financial Analysis: Tools and Techniques
Since the required investment in accounts receivable and inventories is normally much more than twice the credit obtained from current payables and accruals, it should be clear that successful growth requires extensive funding of additional working capital. Add to this the funds required for any expansion of physical facilities or for contractual arrangements to support the growth in sales. The pattern of sales, operating assets (working capital plus fixed and other assets supporting operations), and profits of the typical growing company will look something like the graph shown in Figure 3–7, where growth requires additional working capital every single year as receivables and inventories expand. This growth is only partially offset by increasing accounts payable. Periodically, new investments must be made in expanded facilities, as is indicated by the jump in the operating assets in 2003 and again in 2006. The asset column continues to grow as long as volume growth persists, and constant funding of this increase will be necessary through a combination of profit and other sources. The dotted funding line indicates the total need for funds required to finance growing operating assets, reduced by total after-tax profits in every year. It is assumed that an amount equal to annual depreciation is spent every year on maintaining the facilities. No dividend payments have been allowed for in this line, and as a result the actual funding need is understated. Note that growing profits in the later years are able to gradually reduce the total funding requirements.
F I G U R E 3–7
Typical Growth Pattern Sales Operating assets Aftertax profit
1,600
Funding need Funding after dividends
1,600
1,400
1,400
1,200
1,200
1,000
1,000
800
800
600
600
400
400
200
200
0
0 1999
2000
2001
2002
2003
2004
2005
2006
hel78340_ch03.qxd
9/27/01
11:00 AM
Page 73
CHAPTER 3 Managing Operating Funds
73
F I G U R E 3–8
Managed Decline Pattern Sales Operating assets Aftertax profit
1,600
Funding need Funding after dividends
1,600
1,400
1,400
1,200
1,200
1,000
1,000
800
800
600
600
400
400
200
200
0 –200
1999
2000
2001
2002
2003
2004
2005
2006
0 –200
When dividend payments are provided for, however—in this case rising gradually from $20 in 1997 to $40 in 2004—what was essentially a level funding need becomes a steadily growing requirement for permanent funding, as shown in the solid line. By now it should be clear that successful growth typically requires an ongoing and growing funding commitment, which must be financed over the long term through the use of additional owners’ equity and long-term debt. Frequently, reinvestment of profits alone is not a sufficient source, because in a high-growth business, the contribution from the profit margin might be far outweighed by the cumulative funding demands (as Chapter 5 details).
Decline In the opposite case, when a business declines in volume and is deliberately managed to achieve such shrinkage efficiently—a difficult assumption not always realized—the company will in fact turn into a strong generator of cash. Here the reverse of the growth situation prevails. As sales decline, management must carefully seek to reduce operations, working capital, and other operating assets to match the decline in volume, thus releasing the funds that had been tied up over time. This idealized situation is demonstrated in Figure 3–8. Note the dramatic decline in the basic funding needs, which turned into positive funds generation during the last two years. When dividend payments of as much as 50 percent of after-tax profits are assumed in every year, the funding requirements decline more slowly, but still represent only a fraction of the level at the beginning of the period.
hel78340_ch03.qxd
9/27/01
74
11:00 AM
Page 74
Financial Analysis: Tools and Techniques
Basically, the ability of the business system to release cash depends on the careful removal of all layers of activity that no longer need to be supported. A proportional shrinkage of receivables and inventories, partially offset by declining payables, becomes the major potential cash source, apart from the disposal of other assets no longer needed. If the decline pattern becomes precipitous or cannot be managed properly, however, the specter of inventory markdowns, operating inefficiencies, and emergency actions will seriously impede the release of funds. Under these conditions, real difficulties can arise and the expected cash flow might not materialize.
Seasonal Variations A fairly large number of industries experience distinct seasonal operating patterns (specific months or weeks of high sales, followed by a dramatic decline in demand). These ups and downs repeat themselves quite predictably. Examples are most common in retailing operations, many of which are geared to special holiday periods or specific customer segments with seasonal style or gift requirements. Producers of seasonal items, like snowmobiles or bathing suits, will experience high fluctuations in demand, unless they can sell into global markets that have offsetting climates, or diversify their offerings. Similar patterns impact businesses such as canneries that process specific crops or other seasonal foods, or service firms that prepare income tax returns. Common to all seasonal businesses is a funds cycle with large short-term swings during the period of a year or less. The financial implications of such a pattern are quite obvious. During the low point of demand, ongoing operations have to be supported with cash from internal or external sources, unless the business can be shut down, as some seasonal resorts are. In many seasonal manufacturing businesses, inventories are gradually built up, either through production or through purchases from suppliers. As was the case in our earlier example, funding for this buildup must come from credit, loans, and owners’ equity. Once the selling activity begins, growing amounts of receivables due from customers buying on normal credit terms have to be funded by the company. It is not until the first receivables are actually collected that cash starts flowing back into thebusiness. The financial lags are usually such that collection of the receivables from peak sales will occur well after the peak of funding requirements has occurred. Figure 3–9 demonstrates a typical seasonal pattern on a month-by-month basis which reflects the dramatic rise and fall in funding needs over the year, before any dividends are even considered. In this case, management must make several critical decisions. Among them are the size of the buildup of inventories needed to support anticipated demand, the level of operating and other expenditures to be made during the different phases of the operating cycle, and the nature of the funding to finance the bulge in requirements. Contingencies—such as lower-thanexpected demand or prices, or both, delays in collections from customers, or the
hel78340_ch03.qxd
9/27/01
11:00 AM
Page 75
CHAPTER 3 Managing Operating Funds
75
F I G U R E 3–9
Typical Seasonal Pattern 1,400
Sales Operating assets Aftertax profit Funding need
1,200 1,000 800 600 400 200 0 –200 Jan.
Feb.
Mar.
Apr.
May
June
July
Aug.
Sep.
Oct.
Nov.
Dec.
time involved in arranging for short-term financing with banks and other lenders— must be allowed for. Otherwise, the business could find itself strapped because its own financial obligations must be met well before collections are made. We’ll discuss applying turnover relationships and the aging of receivables as a means of judging the effectiveness of asset use by management in Chapter 4. Under highly seasonal conditions such relationships become unstable, because lags and surges in the accounts within the period spanned by financial statements make most ratio comparisons difficult. As we’ll see in Chapter 5, a more direct evaluation of a seasonal business is possible. Rather than comparing quarterly or year-end financial statements, a month-to-month (or week-to-week) analysis of funds movements and a careful assessment of changes in the funds cycle of the company from peak to peak, or trough to trough can be done.
Cyclical Variations A variant of the seasonal picture is the cyclical pattern of funds movements. It mainly reflects external economic changes that impact the company over a period of several years. Economic variations and specific industry cycles are generally long term and not as regular and predictable as seasonal variations. Economic swings that affect a business or industry tend to bring many more variables into play, such as changes in raw materials, prices and availability, competitive conditions in the market, and capital investment needs. Nevertheless, the cash flow principles we observed in dealing with the seasonal pattern apply here as well.
hel78340_ch03.qxd
9/27/01
11:00 AM
Page 76
76
Financial Analysis: Tools and Techniques
For Example
AM FL Y
Funds lags during a cyclical upturn or downturn tend to be magnified by a mostly unavoidable lag in decision making. As conditions begin to change, it can be very difficult for management to gauge, from daily experience, whether the economy or the market is undergoing a long-term shift and what the specific timing is likely to be. Thus a cyclical downturn results in significant challenges: First, management must recognize, with reasonable confidence, that a turning point has indeed arrived. Next, management must prevent inventories from rising by curtailing purchases and production. This is usually followed by reducing staffing levels, and by cutting ongoing costs wherever possible. Careful management of credit, both extended and used, becomes critical as well. Meeting these challenges is easier said than done, because data on current economic trends available at any one time tend to lag significantly behind actual conditions, while economic forecasts often fall short of predicting both the timing and the degree of economic change.
TE
A gradual downturn in housing construction will leave many producers and wholesalers of building materials with inventories in excess of declining demand. As the sales slump accelerates, and prices of lumber, plywood, and other commodities fall, management faces a funding crisis. Continuing normal production will transform raw material into products that cannot be sold; thus, production must be curtailed. Lower volume and prices also decrease the eventual cash flow generated from current sales, while the stream of collections from past higher sales begins to run out. Figure 3–10 demonstrates a typical cyclical pattern, where sales volume and prices swing with economic conditions, but, due to the factors just mentioned, operating asset levels and their accompanying funding needs lag behind the volume changes. Note the steady increase in funding required during the decline phase is brought about by a combination of rising investment (mostly a buildup of working capital) and plummeting profits. If dividends are maintained at the level of $30, and if we assume that these are paid every year, the funding line rises to a new high, indicating that the company isn’t able to make up for the funds drain of the cyclical decline. In the cyclical upswing, lags in decision making can cause inventory and production levels to be insufficient as sales volume begins to surge. To compensate, extra shifts or outside purchases might be used, even though the costs incurred with these alternatives are typically higher than normal and will depress profitability. Growing sales will also raise the amount of receivables credit extended to customers. Thus, a cyclical boom will likely require the infusion of additional funds to provide the increased working capital needed and to finance increased physical operations. The latter might involve additional investment in plant and facilities. Overall, it can be said that a cyclical upswing will usually require an increase in medium- to long-term financing to support added levels of working capital and
Team-Fly®
hel78340_ch03.qxd
9/27/01
11:00 AM
Page 77
CHAPTER 3 Managing Operating Funds
77
F I G U R E 3–10
Typical Cyclical Pattern Sales Operating assets Aftertax profit
1,200
Funding need Funding after dividends
1,200
1,000
1,000
800
800
600
600
400
400
200
200
0
0
–200
–200 1999
2000
2001
2002
2003
2004
2005
2006
other financial requirements. A downswing, however, will first result in rising inventories—until management can adjust its operations—and then will begin to release cash, which can be used to repay credit obligations. The latter condition, however, will hold true only if both working capital and production levels are carefully managed downward. In summary, variability in funds flows is caused by management actions, by external conditions, or by both. We know that a business operating in a steady state must maintain a permanent stock of working capital, as well as properties, facilities, equipment, and other assets. As a general rule of thumb, the amount of funds tied up in current assets far exceeds trade credit sources and normal shortterm borrowings. Therefore, when significant variability in the level of operations is introduced, major shifts in the company’s financial condition might be caused by changes in working capital alone. Funding for other needs, such as investments in facilities or infrastructure and major spending programs, must be superimposed on this pattern. In Chapter 4, we’ll discuss these issues in the context of the techniques of forecasting funds requirements.
Generalized Funds Flow Relationships At this point, it’s useful once again to examine the overall relationships of funds movements in a generalized framework, as shown in Figure 3–11. The diagram is applicable to any type of business, large or small. We have added flow lines, which show the potential funds movements and linkages between the main accounts of the balance sheet and the income statement. A summary, in terms of our
hel78340_ch03.qxd
9/27/01
11:00 AM
Page 78
78
Financial Analysis: Tools and Techniques
F I G U R E 3–11
Generalized Funds Flow Model Management Decision Context Investment
Operations
Financing
Sales revenue Current assets
Current liabilities Cost of sales Long-term liabilities
Fixed assets
Other assets
Writeoffs (noncash)
Investments (increases) in current, fixed, and other assets are uses of cash; reductions in any asset are sources of cash.
Operating expenses Shareholders’ equity Net income or loss
Profitable operations are a source of cash; losses drain cash from the system. Note: Accounting write-offs like depreciation or special provisions do not represent cash and must be adjusted for (reversed) to arrive at cash flow.
Trade credit, accruals, and new short- and long-term financing (increases in liabilities and stock issues) are sources of cash; repayments of debt, dividends, and repurchases of stock are uses of cash.
familiar management decision context, of the sources and uses of the ultimate cash flows is given at the bottom of the diagram. This representation will be a useful reference when we discuss the interpretation of cash flow statements in the next section, as we follow the convention of the three decisional areas, and the general rules governing cash inflows and outflows.
Interpreting Funds Flow Data We’re now ready to examine in more detail the use and implications of a company’s funds flow information, as normally represented in its cash flow statements. As we discussed in Chapter 2, companies that are publicly held and publish regular financial statements are required by the SEC to provide a statement of cash flows along
hel78340_ch03.qxd
9/27/01
11:00 AM
Page 79
CHAPTER 3 Managing Operating Funds
79
with balance sheets and income statements. Where such statements aren’t readily available, however, or in situations where the analyst wishes to project future funds movements, it’s relatively straightforward to develop meaningful cash flow statements from standard balance sheets and income statements. With the help of the cash flow statement, we can develop many insights about the actual funds changes that took place, and also obtain clues for further analysis of the nature and quality of management decisions in operations, investments, and financing. In this section, we’ll illustrate how to quickly draw up a basic cash flow statement from available balance sheets and income statements, and discuss the major principles involved in transforming this accounting information into the funds flow pattern in which we are interested. For this purpose, we’ll again use the 1997 and 1996 TRW Inc. financial statements originally shown in Chapter 2 as Figures 2–9 and 2–11. We’ll work back from these to develop a derived cash flow statement, which we can then compare to the more detailed one published by TRW. Not having access to the detailed records of the company, we’ll find that our own version of the cash flow statement will approximate, but not be identical to, the key funds movements shown in TRW’s statement. This is because some informational details required are not directly represented on the published statements. We’ll begin with a look at the differences in the key balance sheet items between the two dates, and sort these into a listing of funds sources and uses as a convenient way of identifying positive and negative cash flows. This format is called a sources and uses statement, mainly distinguished from the formal cash flow statement by the arrangement of the information, which in the latter case follows our three familiar decisional areas. Then we’ll turn to the income statement to obtain additional details necessary to expand our insights in the operational area of funds movements. The objective is not accounting refinement, but simply an understanding of the principles involved in transforming data about key changes into cash flow patterns. TRW’s consolidated balance sheets are reproduced as Figure 3–12, which also shows changes in the accounts between the two balance sheet dates. To develop a cash flow statement, these changes must be classified as either funds uses or sources. We’ve done this in Figure 3–13, where increases and decreases in assets and liabilities are assigned to the appropriate categories, following the rules we displayed earlier in Figure 3–11. However, some of the balance sheet categories are too broad for our purpose. As a result, several of the funds flows cannot be specifically delineated: • •
Net profit (or loss) from operations is not recognized as such, but is part of the net change in retained earnings. Cash dividends are also immersed in the net change in retained earnings.
hel78340_ch03.qxd
9/27/01
11:00 AM
Page 80
80
Financial Analysis: Tools and Techniques
F I G U R E 3–12 TRW INC. AND SUBSIDIARIES Consolidated Balance Sheets at December 31 ($ millions)
Assets Current assets: Cash and cash equivalents . . . . . . . . . . . . . . Accounts receivable . . . . . . . . . . . . . . . . . . . . Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . Deferred income taxes . . . . . . . . . . . . . . . . . . Total current assets . . . . . . . . . . . . . . . . . . . Property, plant, and equipment at cost . . . . . . . Less: Allowances for depreciation and amortization . . . . . . . . . . . . . . . . . . . . . Total property, plant, and equipment —net . . . . . . . . . . . . . . . . . . . . . . . . . . . Intangible assets: Intangibles arising from acquisitions . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less: Accumulated amortization . . . . . . . . . . . . Total intangible assets—net . . . . . . . . . . . . . Investments in affiliated companies . . . . . . . . . Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . Liabilities and Shareholders’ Investment Current liabilities: Short-term debt . . . . . . . . . . . . . . . . . . . . . . . Accrued compensation . . . . . . . . . . . . . . . . . . Trade accounts payable . . . . . . . . . . . . . . . . . Other accruals . . . . . . . . . . . . . . . . . . . . . . . . Dividends payable . . . . . . . . . . . . . . . . . . . . . Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . Current portion of long-term debt . . . . . . . . . . . Total current liabilities . . . . . . . . . . . . . . . . . Long-term liabilities . . . . . . . . . . . . . . . . . . . . . . Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . Deferred income taxes . . . . . . . . . . . . . . . . . . . Minority interests in subsidiaries . . . . . . . . . . . . Shareholders’ investment: Serial Preference Stock II . . . . . . . . . . . . . . . . Common stock . . . . . . . . . . . . . . . . . . . . . . . . Other capital . . . . . . . . . . . . . . . . . . . . . . . . . . Retained earnings . . . . . . . . . . . . . . . . . . . . . Cumulative translation adjustments . . . . . . . . Treasury shares—cost in excess of par . . . . . Total shareholders’ investment . . . . . . . . . . Total liabilities and shareholders’ investment . .
Source: Adapted from 1997 TRW Inc. annual report.
1997
1996
Change
$
70 1,617 573 79 96 ______ 2,435 ______ 6,074
$ 386 1,378 524 69 424 ______ 2,781 ______ 5,880
$ 316 239 49 10 328 _______ 346 _______ 194
3,453 ______
3,400 ______
53 _______
2,621
2,480
141
673 232 ______ 905 ______ 94 ______ 811 139 404 ______ $6,410 ______
258 31 ______ 289 ______ 78 ______ 211 51 376 ______ $5,899 ______
415 201 _______ 616 _______ 16 _______ 600 88 28 _______ 511 _______
$ 411 338 859 846 38 99 128 ______ 2,719 ______ 788 1,117 57 105
$
52 386 781 775 39 52 72 ______ 2,157 ______ 767 458 272 56
$ 359 48 78 71 1 47 56 _______ 562 _______ 21 659 215 49
1 78 462 1,776 (130) (563) ______ 1,624 ______ $6,410 ______
1 80 437 1,978 47 (354) ______ 2,189 ______ $5,899 ______
0 2 25 202 177 209 _______ 565 _______ 511 _______
hel78340_ch03.qxd
9/27/01
11:00 AM
Page 81
CHAPTER 3 Managing Operating Funds
81
F I G U R E 3–13 TRW INC. AND SUBSIDIARIES Statement of Balance Sheet Changes For the Year Ended December 31, 1997 ($ millions)
Sources: Decrease in cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . Decrease in deferred income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase in allowances for depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase in accumulated amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase in short-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase in trade accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase in other accruals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase in income taxes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase in current portion of long-term debt . . . . . . . . . . . . . . . . . . . . . . . . Increase in long-term liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase in long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase in minority interests in subsidiaries . . . . . . . . . . . . . . . . . . . . . . . . Increase in other capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 316 328 53 16 359 78 71 47 56 21 659 49 25 ______ $2,078 ______
Uses: Increase in accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase in inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase in prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase in property, plant, and equipment . . . . . . . . . . . . . . . . . . . . . . . . . Increase in intangibles arising from acquisitions . . . . . . . . . . . . . . . . . . . . . Increase in other intangibles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase in investments in affiliated companies . . . . . . . . . . . . . . . . . . . . . . Increase in other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Decrease in accrued compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Decrease in dividends payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Decrease in deferred income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Decrease in common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Decrease in retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Decrease in cumulative translation adjustments . . . . . . . . . . . . . . . . . . . . . Increase in treasury shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
• •
•
239 49 10 194 415 201 88 28 48 1 215 2 202 177 209 ______ $2,078 ______
Depreciation and amortization write-offs are buried in the changes in the respective accounts for accumulated depreciation and amortization. Special items, such as write-offs and adjustments incurred with acquisitions or restructuring activities, are combined in the net amounts of affected accounts. New investments in facilities, as well as acquisitions, disposals, and divestments, are similarly netted out in the balance sheet accounts.
hel78340_ch03.qxd
82
9/27/01
11:00 AM
Page 82
Financial Analysis: Tools and Techniques
TRW’s statement of earnings, or income statement, reproduced in Figure 3–14, provides us with helpful information on the first four elements, while we have to rely on additional information from the company about the amount of new investments, acquisitions, disposals, and divestments. We’ve provided some of these data in summarized form at the bottom of the income statement. The simple sources and uses statement in Figure 3–13 is an indication of the broad financial implications of growth to record sales volume and earnings from continuing operations, the remaining impact of restructuring activities in 1996, and the significant effects of two major acquisitions in 1997. The key net funds sources were: •
•
•
•
• •
A net increase in long-term debt of $659 million, accompanied by an increase of $59 million in the current portion of long-term debt. This change occurred in connection with the $1.0 billion acquisition of BDM International, an information technology company, and the acquisition of an 80 percent interest in Magna International, an automotive component company, for approximately $0.5 billion. A net increase in short-term debt of $359 million, also part of the funding of TRW’s growth and of temporary financing needs related to the acquisitions. A significant reduction of cash and cash equivalents of $316 million, reflecting part of the financing changes put in place during 1997 and the cash transactions involved in the two acquisitions. A reduction in the company’s deferred income tax assets, which represents a timing shift in actual tax payments, effectively using accumulated credit and thereby conserving cash. This was, to a large extent, offset by a reduction in deferred income tax liabilities, and a reverse shift in the timing of tax payments, effectively requiring the use of cash to reduce tax obligations. The two opposing cash flows netted out to a $113 million source. Other sources reflect a variety of working capital changes and minor increases in minority interests and other capital. The period’s depreciation and amortization, which we would expect to be major sources, are so far hidden in the overall changes of the accumulated allowances shown on the balance sheet.
The major net funds uses during 1997 were: • • •
Large increases in intangible assets caused by the acquisition ($415 million) and by other investments ($201 million). An increase of $239 million in accounts receivable, reflecting volume growth and the impact of the acquisitions. A net increase of $194 million in property, plant, and equipment, reflecting new capital spending as well as disposals, and the impact of the
hel78340_ch03.qxd
9/27/01
11:00 AM
Page 83
CHAPTER 3 Managing Operating Funds
83
F I G U R E 3–14 TRW INC. AND SUBSIDIARIES Statements of Earnings For the Years Ended December 31, 1997 and 1996 ($ millions)
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Administrative and selling expenses . . . . . . . . . . . . . . . . . Research and development expenses . . . . . . . . . . . . . . . . Purchased in-process research and development . . . . . . . Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other expenses (income) net . . . . . . . . . . . . . . . . . . . . . . . Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Earnings (loss) from continuing operations before taxes Excluding purchased R&D; special charges (’96) . . . . . . Reported earnings (loss) before income taxes . . . . . . . . Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Earnings (loss) from continuing operations Excluding purchased R&D; special charges (’96) . . . . . . Reported earnings (loss) after income taxes . . . . . . . . . . Discontinued operations, gain on disposition, after tax . . . Net earnings (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Preference dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Earnings (loss) applicable to common stock . . . . . . . . . . . Per share of common stock: Average number of shares outstanding (millions) Diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted net earnings (loss) per share From continuing operations Excluding purchased R&D; special charges . . . . . . . . . Reported . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . From discontinued operations . . . . . . . . . . . . . . . . . . . . . Diluted net earnings (loss) per share . . . . . . . . . . . . . . . . Basic net earnings (loss) per share From continuing operations Excluding purchased R&D; special charges . . . . . . . Reported . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . From discontinued operations . . . . . . . . . . . . . . . . . . . . Basic net earnings (loss) per share . . . . . . . . . . . . . . . . . . Book value per share (year-end) . . . . . . . . . . . . . . . . . . . . Tangible book value per share (year-end) . . . . . . . . . . . . . Other data ($ millions): Depreciation of property, plant, and equipment . . . . . . . . . Amortization of intangibles, other assets . . . . . . . . . . . . . . Capital expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Source: Adapted from 1997 TRW Inc. annual report.
1997
1996
$10,831 8,826 ______ 2,005 684 461 548 75 (3) ______ 1,765 ______
$ 9,857 8,376 _______ 1,481 613 412 — 84 70 _______ 1,179 _______
788 (240) 289 ______
687 302 120 _______
$ 499 (49) — ______ $ (49) — ______ $ (49) ______
$
434 182 298 _______ $ 480 1 _______ $ 479 _______
123.7 123.7
132.8 128.7
$ 4.03 $ (0.40) — ______ $ (0.40) ______
$ 3.27 $ 1.37 $ 2.25 _______ $ 3.62 _______
$ 4.03 $ (0.40) — ______ $ (0.40) ______ $ 13.19 $ 6.58
$ 3.29 $ 1.41 $ 2.31 _______ $ 3.72 _______ $ 17.29 $ 15.62
$
$
480 10 549 154
442 10 500 148
hel78340_ch03.qxd
84
9/27/01
11:00 AM
Page 84
Financial Analysis: Tools and Techniques
•
•
•
acquisitions, accompanied by an increase of $88 million in investments in affiliated companies. A retained earnings decrease of $202 million, despite record earnings from ongoing operations, due to a major write-off of purchased research and development of $544 million and dividend payments of $154 million. Repurchases of shares in the open market that amounted to $209 million, a continuation of the share repurchase policy TRW has carried out over several years. Unfavorable currency translation that caused a drain of $177 million.
Although we do, at this point, have a broad picture of TRW’s sources and uses of funds, we should make a few modifications to our statement using what information is readily available to us: 1. The net change in retained earnings can be separated into profit or loss from operations and cash dividends paid. In the case of TRW, we know from the income statement that there was net income (earnings) for 1997 of $499 million from ongoing operations before a write-off of $548 million of purchased research and development after the acquisition of BMD International. The net amount, a loss of $49 million, must have been subtracted from retained earnings. The income statement further indicated that cash dividends paid were $154 million, which was also subtracted from retained earnings. The total of these two amounts is $203 million, very close to the change in retained earnings of $202. The $1.0 million is due to the difference between dividends declared and dividends actually paid, and to other small adjustments. 2. The amount of depreciation and amortization charged against income during the period should be shown as a positive funds movement, in order to reverse the impact of these noncash charges. Normally the largest is depreciation of plant and equipment, followed by amortization of patents, licenses, and other intangibles. In some cases, depletion of mineral deposits and standing timber is charged. We remember that such write-offs reflect the apportionment of past expenditures and do not involve current cash flows, serving to mask the total cash generation implicit in net income. Therefore, they must be added back to income to arrive at cash flow. This proper practice, however, results in a common misconception—to view depreciation and amortization as actual sources of cash. Remember that depreciation and amortization as such do not create any cash—they are only accounting entries that reduce reported income and thus understate the actual cash flow obtained. They do, of course, directly affect the amount of income taxes paid, but this positive funds impact has already been recognized in the income tax charge which was deducted before
hel78340_ch03.qxd
9/27/01
11:00 AM
Page 85
CHAPTER 3 Managing Operating Funds
85
arriving at net income. In TRW’s case, depreciation and amortization were shown at the bottom of the income statement as $480 million and $10 million, respectively. These amounts should be listed as sources because their addition in effect restores net income to its pre–write-off level. 3. Capital expenditures for new investment are often provided as a line item in published statements and in a company’s annual report. If we did not have direct information about new investments, acquisitions, disposals, and divestments made during the period, we would have to approximate the amount of funds used by arguing that the net change of the property, plant, and equipment account was affected by two main elements: • The amount of depreciation charged during the year. • All the other transactions combined.
Because we know that the net change in TRW’s property, plant, and equipment was an increase of $141 million (increase in gross property of $194 million less increase in allowances for depreciation of $53 million), we can derive the net effect of all the other movements by adding back the amount of depreciation of $480 million, for a net change in investments of $621 million. This result suggests, at the very least, that the actual new investments of $549 million shown below the income statement in Figure 3–14 must have been accompanied by some additional amounts, both positive, due to the acquisitions, and perhaps negative, due to disposals of equipment. We can use the same approach to approximate the net change in intangible investments by adding back the amortization charge of $10 million to the net balance sheet change of $600 million, for a total of $610 million. Note that the company separated intangibles into two categories: those arising from acquisitions (essentially the difference between the purchase price and the recorded value of the assets), and other intangibles, such as intellectual property. As we’ll see, the published cash flow information provided by the company shows the details of the positive and negative movements in this area. Now we can assemble a modified sources and uses statement in Figure 3–15, using the basic information displayed earlier in Figure 3–13. The statement will be improved somewhat by the adjustments we’ve discussed in owners’ equity, net income, and plant and equipment, but will be somewhat lacking in terms of understanding the specific impact of TRW’s two major acquisitions in 1997. We’ve rearranged the derived TRW data in our three familiar areas of management decisions: operations, investment, and financing, as well as by sources and uses to highlight the specific impact of each element. This provides a preliminary picture of the effect of TRW management decisions in 1997. We observe that operational decisions resulted in a net funds source of $951 million, which represents the 1997 net loss of $49 million—adjusted for the writeoff of $548 million of purchased research and development related to the acquisition of BDM International, depreciation of $480 million, amortization of
hel78340_ch03.qxd
9/27/01
11:00 AM
Page 86
86
Financial Analysis: Tools and Techniques
F I G U R E 3–15 TRW INC. AND SUBSIDIARIES Derived Funds Sources and Uses Statement For the Year Ended December 31, 1997 ($ millions)
Sources
$
49
$ 548 480 10 113
AM FL Y
Funds from Operations: Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Write-off of purchased research and development . . . . . . . Depreciation (noncash item) . . . . . . . . . . . . . . . . . . . . . . . . Amortization (noncash item) . . . . . . . . . . . . . . . . . . . . . . . . Change in deferred income taxes (net) . . . . . . . . . . . . . . . Change in current liabilities (payables, accruals, taxes, dividends, etc.) . . . . . . . . . Change in current assets other than cash (receivables, inventories, prepaid expenses) . . . . . . . . Total operational funds flows . . . . . . . . . . . . . . . . . . . . . Net funds from operations . . . . . . . . . . . . . . . . . . . . . . .
Uses
147
— ______ 1,298 ______ 951 ______
Funds for Investment: Capital investments (adjusted for depreciation of $480) . . Investment in intangible assets (adjusted for amortization of $10) . . . . . . . . . . . . . . . . . Purchased research and development . . . . . . . . . . . . . . . . Investment in affiliated companies . . . . . . . . . . . . . . . . . . . Increase in other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . Total investment funds flows . . . . . . . . . . . . . . . . . . . . .
298 _______ 347 _______
621
TE
610 548 88 28 _______ 1,895 _______
Funds from Financing: Increase in short-term debt . . . . . . . . . . . . . . . . . . . . . . . . . Increase in long-term debt (including current portion) . . . . Increase in long-term liabilities . . . . . . . . . . . . . . . . . . . . . . Increase in minority interests . . . . . . . . . . . . . . . . . . . . . . . Decrease in common stock . . . . . . . . . . . . . . . . . . . . . . . . Increase in other capital . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase in treasury shares . . . . . . . . . . . . . . . . . . . . . . . . Currency translation adjustments . . . . . . . . . . . . . . . . . . . . Dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjustments to retained earnings . . . . . . . . . . . . . . . . . . . . Financing funds flows . . . . . . . . . . . . . . . . . . . . . . . . . . Net funds provided by financing . . . . . . . . . . . . . . . . . .
1 ______ 1,170 ______ 628
Change in Cash: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
316 ______ $1,895 ______
359 715 21 49 2 25 209 177 154 _______ 542 _______
$1,895 _______
$10 million, and reduction in deferred taxes of $113 million. The final two items represent changes in working capital elements, with net changes in current liabilities providing a source of $147 million, and net changes in current assets (other than cash; see bottom of statement) amounting to a use of $298 million. Funds required for investment amounted to $1,895 million, which included our derived capital investment figure of $621 million, plus a similarly derived
Team-Fly®
hel78340_ch03.qxd
9/27/01
11:00 AM
Page 87
CHAPTER 3 Managing Operating Funds
87
investment of $610 million in intangible assets. We must also reflect here the known purchase of research and development of $548 million during the acquisition of BDM International in 1997, which was written off against earnings in the same year, as shown above. Smaller uses are the investment in affiliated companies of $88 million, and the increase in other assets of $28 million. Funds from financing decisions, a net amount of $628 million, are characterized by significant increases in TRW’s debt, with short-term debt raised by $359 million and long-term debt growth of $715 million, largely related to the major acquisitions. Other capital grew by $25 million, while repurchases of stock for cash raised treasury shares by $209 million. Currency translations affected cash negatively by $177 million, and dividends paid amounted to $154 million. Minor elements account for the remainder. A check of the company’s annual report reveals that, as we know, actual 1997 capital investment for new property, plant, and equipment was $549 million, as compared to our derived total of $621. We also learn that the total cost of the acquisitions, net of cash acquired, was $1,270 million. This figure could not be directly derived from the balance sheet changes because the acquired assets were in part written off ($548 million of purchased research and development was charged against earnings), and the various assets and liabilities were merged with the balance sheet totals. However, we can regard the combined increase in intangible assets of $1,150 million ($610 million largely due to the acquisitions, and purchased research and development of $540 million) as a reasonable proxy for the cost of the acquisitions, even though this total falls short by $120 million. These differences can only be reconciled by inside information not available in the published data. When we compare TRW’s actual cash flow statement, reproduced in Figure 3–16, to our derived statement in Figure 3–15, we find that, apart from differences in presentation, the figures we have developed are directionally representative. The various items on which the statements disagree—and some of them are significant—require more detailed knowledge. This is particularly true of details in the financing section, which reflects a lot of information not available to us, and in the investment section, where the major aspect is the acquisition of BDM International and Magna International. The impact of these acquisitions, which were made for cash, is reflected there as the original total amount of $1,270, financed temporarily by a large increase in short-term debt. As the three companies were combined, assets and liabilities were consolidated and the difference between the price and the recorded values brought about the sizable increase in intangibles (goodwill). For purposes of the TRW cash flow statement, the intangibles increases we had recognized separately are part of acquisition cost shown, and the changes specified in the financing section are designed to highlight the acquisition transaction. From an overall standpoint, however, the totals in the three major funds flow categories are reasonable approximations of the TRW presentation, varying by no more than $78 million in the largest category—the funds used for investment—and by far less in the other two, $3 million and $52 million respectively.
hel78340_ch03.qxd
9/27/01
11:00 AM
Page 88
88
Financial Analysis: Tools and Techniques
F I G U R E 3–16 TRW INC. AND SUBSIDIARIES Statements of Cash Flows For the Years Ended December 31, 1997 and 1996 ($ millions)
1997
1996
$ (49)
$ 480
Operating Activities: Net earnings (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjustments to reconcile net earnings (loss) to net cash provided by continuing operations: Purchased in-process research and development . . . . . Depreciation and amortization . . . . . . . . . . . . . . . . . . . . . Deferred income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . Discontinued operations . . . . . . . . . . . . . . . . . . . . . . . . . Other—net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Changes in assets and liabilities, net of effects of businesses acquired or sold: Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Inventories and prepaid expenses . . . . . . . . . . . . . . . . . . Accounts payable and other accruals . . . . . . . . . . . . . . . Other—net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash provided by operating activities . . . . . . . . . . . . . .
32 (26) (166) (1) ______ 954
(46) 8 298 (24) ______ 711
Investing Activities: Capital expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . Acquisitions, net of cash acquired . . . . . . . . . . . . . . . . . . Net proceeds from divestitures . . . . . . . . . . . . . . . . . . . . Other—net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash provided by (used in) investing activities . . . . . . .
(549) (1,270) — 2 ______ (1,817)
(500) (76) 789 34 ______ 247
Financing Activities: Increase (decrease) in short-term debt . . . . . . . . . . . . . . Proceeds from debt in excess of 90 days . . . . . . . . . . . . Principal repayments in excess of 90 days . . . . . . . . . . . Dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Acquisition of common stock . . . . . . . . . . . . . . . . . . . . . . Other—net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash provided by (used in) financing activities . . . . . . . Effect of exchange rate changes on cash . . . . . . . . . . . . . Increase (decrease) in cash and cash equivalents . . . . . . Cash and cash equivalents at beginning of year . . . . . . . . Cash and cash equivalents at end of year . . . . . . . . . . . . .
912 113 (89) (154) (247) 41 ______ 576 (29) ______ (316) 386 ______ $ 70 ______
(127) 51 (91) (148) (361) 51 ______ (625) (6) ______ 327 59 ______ $ 386 ______
Supplemental Cash Flow Information: Interest paid (net of amount capitalized) . . . . . . . . . . . . . Income taxes paid (net of refunds) . . . . . . . . . . . . . . . . . Source: Adapted from 1997 TRW Inc. annual report.
548 490 116 — 10
$
76 78
— 452 (182) (298) 23
$
89 615
hel78340_ch03.qxd
9/27/01
11:00 AM
Page 89
CHAPTER 3 Managing Operating Funds
89
To summarize, in this section we constructed a cash flow statement that goes beyond simply listing the changes readily observed in a comparison of beginning and ending balance sheet accounts. We achieved this by making some broad adjustments in several of the accounts. The purpose of the refinements was to highlight significant results that reflect management decisions involving investments, operations, and financing. If a company’s cash flow statement is not made available as a matter of course, the analyst can usually approximate the main elements of the statement, which an insider could prepare by going through the basic adjustment process we’ve demonstrated.
Funds Management and Shareholder Value It will be useful to reflect once more on the nature of funds movements in the context of shareholder value creation. We’ve demonstrated the complex interrelationship of funds movements, driven by management decisions, external forces, and the intrinsic nature of a company’s business. We’ve further shown how to determine and illustrate the impact of funds movements on cash flows. The overriding principle for successful management of operating funds is constant attention to the economical use of the resources these funds represent. The best-managed companies tailor their information systems and management incentives to minimize funds use relative to the level of each activity. If the foundation of shareholder value creation is to earn returns on the resources employed at levels above shareholder expectations, taking a “scarcity” approach to resource deployment should be natural for managers at all levels. Such thinking must not be limited to funding new capital outlays alone, as we’ll discuss in Chapters 7 and 8, but must reach into all aspects of the business, including working capital management, employment practices, funding of research, product and service development, marketing and promotional programs, and so on. We’ll now briefly discuss some of the key elements involved in managing operational funds.
Cash Management As we’ve stated before, all management decisions and the funds movements caused by them eventually materialize in the form of a cash impact. But we also must realize that a company’s cash balance at any one time represents a resource commitment, even though its movements are more frequent and extensive than those of other investments. The principle that applies to this resource is the same as with any other resource: Minimize its size relative to the needs it supports, and obtain the greatest possible return by investing cash balances in ways that reflect its unique characteristics. Therefore, the economics of sound cash management requires that any time there is a lag in cash receipts it should be minimized, and disbursements should be
hel78340_ch03.qxd
9/27/01
11:00 AM
90
Page 90
Financial Analysis: Tools and Techniques
made no sooner than required by commercial and legal terms. Ways to achieve time compression range from the use of lockboxes, to which remittances from customers are mailed for speedier processing, to the growing use of electronic funds transfers, which allows immediate collection of amounts due without the delays of paperwork. Effective banking relationships are a great asset in this process, and companies with widespread locations will attempt to concentrate cash management into regional processing arrangements. Minimization of cash balances can be achieved by transferring any excess cash into marketable securities of short maturities, including U.S. treasury bills, commercial paper issued by corporations, and certificates of deposit issued by banks. While returns from these temporary investments will not approach the returns from a company’s normal business activities, the trade-off between leaving cash idle versus earning a modest return until the cash can be used for longer-term investments, dividends, or repurchase of shares, will be positive and therefore in the shareholders’ interest.
Working Capital Management Investments in customer credit in the form of accounts receivable, and in inventories of goods or materials, are long-term resource commitments as part of the stock of working capital, as we discussed earlier. Minimization of these investments relative to the level and pattern of a company’s operations is a crucial element in the total management of operating funds. The key to successful management of customer credit and inventories is a clear understanding of the economic trade-offs involved. Credit terms are a function of the competitive environment as well as of a careful assessment of the nature and creditworthiness of customers. For example, the issue might be whether extended credit terms, and the resulting rise in receivables outstanding, are compensated for by the contribution from any incremental sales gained. Similarly, extending normal credit to marginal customers has to be judged in terms of the risk of late payment or default versus the contribution from the sales gained. Techniques in the customer credit area include constant updating of credit performance, aging of accounts receivable into time categories, and developing sound criteria for credit extension. Inventory management in successful companies has evolved into a rigorous process of asset minimization. Information technology has permitted a general reduction in inventory levels, whether in manufacturing, wholesaling, or retailing. In an effort to push inventories as low as possible, techniques such as just-in-time deliveries by suppliers to their customers’ manufacturing or trading locations, and carefully scheduled restocking triggered by instantaneous purchase data from major wholesalers and retailers, have become widespread. In effect, these techniques have created a very close relationship between major suppliers and major customers, often with electronic linkages of inventories, order processing, and production scheduling. Such ties allow for timely coordination of schedules and minimization of inventories on both sides.
hel78340_ch03.qxd
9/27/01
11:00 AM
Page 91
CHAPTER 3 Managing Operating Funds
91
Normal trade credit from suppliers in the form of accounts payable helps to offset receivables and inventories. Here the appropriate principle is to make use of the credit terms extended, but to watch for potential favorable trade-offs such as discounts for early payment. Accounts payable is one form of financing working capital, and therefore, maximum use of trade terms is appropriate. If discounts offered for early payment are attractive—for example, 2 percent for payment in 10 days rather than 30 days amounts to a sizable interest rate of 36 percent per year (2 percent gained for a 20-day speedup in remittance)—there is an obvious advantage in using less-expensive bank credit in order to remit to the vendor in 10 days. Deliberately exceeding the normal credit terms might make the interest trade-off more favorable, but there is the risk of affecting the company’s credit standing if delays beyond the terms granted become habitual. Sound management of supplier credit, as was true with customer credit, relies on current up-to-date information on accounts and aging of payables to ensure proper payment. As we discussed earlier, funding of working capital must be considered a long-term commitment, unless the business is characterized by significant seasonal or cyclical fluctuations. Given that even tightly managed receivables and inventories require long-term financial support, successful management of operational funding requires the use of a combination of reinvested earnings and longterm debt, augmented as needed by temporary short-term funding.
Investment Management Funding of operations also involves periodic investments in facilities, programs, and other long-term resource commitments beyond working capital needs. As we’ll discuss in Chapters 7 and 8, the principles of sound investment management are no different in terms of shareholder value creation—the minimization of funds needs relative to the expected benefits is paramount. The main complications arise because of the longer time frame and greater degree of uncertainty surrounding the expectations about the cash flows to be generated. The techniques of analysis are somewhat more involved, but still are based on the basic notion of cash flow trade-offs. The funding for such commitments will naturally tend to have a longer time horizon as well.
Key Issues The following is a recap of the key issues raised directly or indirectly in this chapter. They are enumerated here to help the reader keep the materials discussed within the perspective of financial theory and business practice. 1. Operational funding needs and sources are woven into the larger systems context of managing the company for shareholder value, and must also be viewed from both a short-term and a long-term perspective. It is not appropriate to attempt to separate specific operational funding issues from this larger context.
hel78340_ch03.qxd
9/27/01
92
11:00 AM
Page 92
Financial Analysis: Tools and Techniques
2. Operational funding is affected by both internal and external conditions and causes, which must be understood in terms of the business environment, economic conditions, and specific company processes and policies. Identifying the key drivers of operational funds patterns and tracing their impact over appropriate periods of time is a valuable effort for minimizing unexpected shortfalls or ineffective use of resources. 3. Operational funding requirements and the trade-offs surrounding them are special applications of the broader economic principles that govern all resource commitments and sources. The main difference lies in the timing of the flow patterns, which are generally more short-term oriented, but still belong within the larger framework of resource management. 4. Several key questions arise as funds movements are analyzed. Most relate to the types of funds commitments (uses) made compared to the sources of funds available. Are enough long-term funds provided to fund ongoing growth in working capital and fixed asset expansion given a strategic context? Are most sources of funds temporary loans and credit extensions? Is the business counting on profits to fund peak needs that might exceed such expectations? 5. As modern management embraces greater degrees of cash flow thinking, the interpretation and use of cash flow statements increases, as does the amount of detail presented in them. Analysis of published financial statements materially benefits from these displays of cash flow patterns, and familiarity with the development and limitations of the statements is a necessary skill for the financial analyst and manager. 6. Funds flow patterns represent the essential nature of business decisions, and are the key ingredient in shareholder value creation. The challenge to the analyst and manager is to understand the difference between economic cash flows and noncash accounting transactions, and to interpret the pattern of funds movements accordingly. Judging the performance and value of a business largely depends on such discriminating insights.
Summary In this chapter, we’ve demonstrated the funds flow cycle involved in any business, large or small, and its implications for management. We began with a simple illustration of basic funds movements, and then discussed operating funds cycles from the standpoints of manufacturing, sales, and service. We observed the nature and behavior of working capital, highlighted the impact of different types of variability in operations, and demonstrated the effect of funds lags on the nature and duration of financing required to support a business. Major insights gained included the need to consider the permanence of basic working capital requirements, the financial drain encountered even with successful growth, and the potential funds release from decline in volume.
hel78340_ch03.qxd
9/27/01
11:00 AM
Page 93
CHAPTER 3 Managing Operating Funds
93
We then turned to a demonstration of how public financial statement information can be used to develop a meaningful cash flow statement, which summarizes the total cash flow picture of a business. It became clear that much of the insight to be gained about the cash impact of a company’s decision pattern could be expressed by analyzing balance sheet changes and supplementary income statement information. At the same time, the need for specific detail not normally published was apparent, in order to refine the cash flow information. Fortunately, publicly held companies publish detailed cash flow statements arranged in a standard format, allowing direct access to the major cash effects of significant decisions. In essence, funds flow analysis is a broad-brush dynamic view of the management of the business. It relates changes in major conditions to their key financial implications by reconstructing the cash implications of major transactions during the period. The techniques are relatively simple, requiring only basic accounting knowledge to provide this extra dimension in assessing balance sheets and income statements. The transformation into cash flow thinking achieved by funds flow analysis matches the dynamics of the systems concept we discussed in Chapter 2. It is also a precursor to the topics covered in later chapters, where cash flow patterns and expectations are a significant aspect of financial analysis techniques and practices.
Analytical Support Financial Genome, the commercially available financial analysis and planning software described in Appendix I, has the capability to develop cash flow statements from databases, spreadsheets, and direct inputs. (see “Downloads Available” on p. 431)
Selected References Anthony, Robert N. Essentials of Accounting. 5th ed. Reading, MA: Addison Wesley, 1993. Brealey, Richard, and Stewart Myers. Principles of Corporate Finance. 5th ed. Burr Ridge, IL: Irwin/McGraw-Hill, 1996. Ross, Stephen; Randolph Westerfield; and Bradford Jordan. Fundamentals of Corporate Finance. 4th ed. Burr Ridge, IL: Irwin/McGraw-Hill, 1998. Weston, J. Fred, and Thomas E. Copeland. Managerial Finance. 10th ed. Hinsdale, IL: Dryden Press, 1992.
This page intentionally left blank.
hel78340_ch04.qxd
9/27/01
11:07 AM
Page 95
CHAPTER 4
ASSESSMENT OF BUSINESS PERFORMANCE
W
hen we wish to assess the performance of a business, we’re looking for ways to measure the financial and economic consequences of past management decisions that shaped investments, operations, and financing over time. The important questions to be answered are whether all resources were used effectively, whether the profitability of the business met or even exceeded expectations, and whether financing choices were made prudently. Shareholder value creation ultimately requires positive results in all these areas—which will bring about favorable cash flow patterns exceeding the company’s cost of capital. As we’ll see, there is a wide range of choices among many individual ratios and measures, some purely financial and some economic. No one ratio or measure can be considered predominant. In this chapter, we’ll demonstrate primarily the analysis of business performance based on published financial statements. These represent the most common data source available for the purpose, even though they are not designed to reflect economic results and conditions. We’ll also discuss the more important measures that help assess economic performance aspects. Our focus will be on key relationships and indicators that allow the analyst to assess past performance and also to project assumed future results (as discussed in Chapter 5). We’ll point out their meaning as well as the limitations inherent in them. In the final chapters we’ll discuss the larger context of valuing a company or its parts in economic terms, a process that is based on an intense assessment of performance drivers and strategic positioning, and that requires developing expected cash flow results for which past performance is only a starting point.
Ratio Analysis and Performance Because there are so many tools for doing performance assessment, we must remember that different techniques address measurement in very specific and often 95
Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
hel78340_ch04.qxd
9/27/01
11:07 AM
Page 96
96
Financial Analysis: Tools and Techniques
narrowly defined ways. One can be tempted to “run all the numbers,” particularly given the speed and ease of computer spreadsheets. Yet normally, only a few selected relationships will yield information the analyst really needs for useful insights and decision support. By definition, a ratio can relate any magnitude to any other—the choices are limited only by the imagination. To be useful, both the meaning and the limitations of the ratio chosen have to be understood. Before beginning any task, therefore, the analyst must define the following elements: • The viewpoint taken. • The objectives of the analysis. • The potential standards of comparison.
TE
AM FL Y
Any particular ratio or measure is useful only in relation to the viewpoint taken and the specific objectives of the analysis. When there is such a match, the measure can become a standard for comparison. Moreover, ratios are not absolute criteria: They serve best when used in selected combinations to point out changes in financial conditions or operating performance over several periods and as compared to similar businesses. Ratios help illustrate the trends and patterns of such changes, which, in turn, might indicate to the analyst the risks and opportunities for the business under review. A further caution: Performance assessment via financial statement analysis is based on past data and conditions from which it might be difficult to extrapolate future expectations. Yet, any decisions to be made as a result of such performance assessment can affect only the future—the past is gone, or sunk, as an economist would call it. No attempt to assess business performance can provide firm answers. Any insights gained will be relative, because business and operating conditions vary so much from company to company and industry to industry. Comparisons and standards based on past performance are especially difficult to interpret in large, multibusiness companies and conglomerates, where specific information by individual lines of business is normally limited. Accounting adjustments of various types present further complications. To deal with all these aspects in detail is far beyond the scope of this book, although we’ll point out the key items. The reader should strive to become aware of these issues and always be cautious in using financial data. To provide a coherent structure for the many ratios and measures involved, the discussion will be built around three major viewpoints of financial performance analysis. While there are many different individuals and groups interested in the success or failure of a given business, the most important are: • Managers. • Owners (investors). • Lenders and creditors. Closest to the business on a day-to-day basis, but also responsible for its long-range performance, is the management of the organization, whether its
Team-Fly®
hel78340_ch04.qxd
9/27/01
11:07 AM
Page 97
CHAPTER 4 Assessment of Business Performance
97
members are professional managers or owner/managers. Managers are responsible and accountable for operating efficiency, the effective deployment of capital, useful human effort, appropriate use of other resources, and current and long-term results—all within the context of sound business strategies. Next are the various owners of the business, who are especially interested in the current and long-term returns on their equity investment. They usually expect growing earnings, cash flows, and dividends, which in combination will bring about growth in the economic value of their “stake.” They are affected by the way a company’s earnings are used and distributed, and by the relative value of their shares within the general movement of the security markets. Finally, there are the providers of “other people’s money,” lenders and creditors who extend funds to the business for various lengths of time. They are mainly concerned about the company’s liquidity and cash flows that affect its ability to make the interest payments due them and eventually to repay the principal. They’ll also be concerned about the degree of financial leverage employed, and the availability of specific residual asset values that will give them a margin of protection against their risk. Other groups such as employees, government, and society have, of course, specific objectives of their own—the business’ ability to pay wages, the stability of employment, the reliability of tax payments, and the financial wherewithal to meet various social and environmental obligations. Financial performance indicators are useful to these groups in combination with a variety of other data. The principal financial performance areas of interest to management, owners, and lenders are shown in Figure 4–1, along with the most common ratios and measures relevant to these areas. We’ll follow the sequence shown in the figure and discuss each subgrouping within the three broad viewpoints. Later, we’ll relate the key measures to each other in a systems context.
Management’s Point of View Management has a dual interest in the analysis of financial performance: • To assess the efficiency and profitability of operations. • To judge how effectively the resources of the business are being used. Judging a company’s operations is largely done with an analysis of the income statement, while resource effectiveness is usually measured by reviewing both the balance sheet and the income statement. In order to make economic judgments, however, it’s often necessary to modify the available financial data to reflect current economic values and conditions. For purposes of illustration, we’ll again use information from the sample statements of TRW Inc. for 1997 and 1996, which were reproduced in Chapter 2. The same statements are shown here in Figures 4–2 and 4–3. We’ll use this information for the remainder of this chapter. For added convenience, we’ve also expressed the various items on the income statement as a percent of sales, a common
hel78340_ch04.qxd
9/27/01
11:07 AM
Page 98
98
Financial Analysis: Tools and Techniques
F I G U R E 4–1
Performance Measures by Area and Viewpoint Management
Owners
Lenders
Operational Analysis
Investment Return
Liquidity
Gross margin Profit margin EBIT; EBITDA NOPAT Operating expense analysis Contribution analysis Operating leverage Comparative analysis
Return on total net worth Return on common equity Earnings per share Cash flow per share Share price appreciation Total shareholder return
Resource Management
Disposition of Earnings
Asset turnover Working capital management • Inventory turnover • Accounts receivable patterns • Accounts payable patterns Human resource effectiveness Profitability Return on assets (after taxes) Return before interest and taxes Return on current value basis EVA and economic profit Cash flow return on investment Free cash flow
Dividends per share Dividend yield Payout/retention of earnings Dividend coverage Dividends to assets Market Performance Price/earnings ratio Cash flow multiples Market to book value Relative price movements Value drivers Value of the firm
Current ratio Acid test Quick sale value
Financial Leverage Debt to assets Debt to capitalization Debt to equity
Debt Service Interest coverage Burden coverage Fixed changes coverage Cash flow analysis
way of highlighting the relative magnitude of the various categories in relation to the base of sales. In addition, Addendum 4–1 at the end of this chapter contains major selections from the “Notes to Financial Statements,” as published in TRW’s 1997 annual report. They are provided as explanatory background for the company’s key accounting policies, recent restructuring and acquisitions, income tax provisions, deferred income taxes, post-retirement benefits accounting change, debt, and industry segments. Because these items affect the development of many of the ratios in this chapter, the notes will help in understanding some of the choices an analyst must make in using financial statement information.
Operational Analysis An initial assessment of the operational effectiveness for the business as a whole or any of its subdivisions is generally performed through a “common numbers” or percentage analysis of the income statement. Individual costs and expense items
hel78340_ch04.qxd
9/27/01
11:07 AM
Page 99
CHAPTER 4 Assessment of Business Performance
99
F I G U R E 4–2 TRW INC. AND SUBSIDIARIES Consolidated Balance Sheets at December 31 ($ millions)
1997
1996
70 1,617 573 79 96
$ 386 1,378 524 69 424
Assets Current assets: Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Inventories. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2,435
2,781
Property, plant, and equipment at cost . . . . . . . . . . . . . . . . . . Less: Allowances for depreciation and amortization . . . . . .
6,074 3,453
5,880 3,400
Total property, plant & equipment—net . . . . . . . . . . . . . . Intangible assets Intangibles arising from acquisitions . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2,621
2,480
673 232
258 31
Total intangible assets . . . . . . . . . . . . . . . . . . . . . . . . . . . Less: Accumulated amortization . . . . . . . . . . . . . . . . . . .
905 94
289 78
Total intangible assets—net . . . . . . . . . . . . . . . . . . . . . . Investments in affiliated companies . . . . . . . . . . . . . . . . . . . . Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
811 139 404
211 51 376
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$6,410
$5,899
Current liabilities: Short-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . Trade accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . Other accruals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Current portion of long-term debt . . . . . . . . . . . . . . . . . . . .
$ 411 338 859 846 38 99 128
$
Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . .
2,719
2,157
Long-term liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Minority interests in subsidiaries . . . . . . . . . . . . . . . . . . . . . . . Shareholders’ investment: Serial preference stock II. . . . . . . . . . . . . . . . . . . . . . . . . . . Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cumulative translation adjustments . . . . . . . . . . . . . . . . . . Treasury shares cost in excess of par value . . . . . . . . . .
788 1,117 57 105
767 458 272 56
1 78 462 1,776 (130) (563)
1 80 437 1,978 47 (354)
Liabilities and Shareholders’ Investment 52 386 781 775 39 52 72
Total shareholders’ investment . . . . . . . . . . . . . . . . . . . .
1,624
2,189
Total liabilities and shareholders’ investment . . . . . . . . . . . . .
$6,410
$5,899
Source: Adapted from 1997 TRW Inc. annual report.
hel78340_ch04.qxd
9/27/01
11:07 AM
Page 100
100
Financial Analysis: Tools and Techniques
F I G U R E 4–3 TRW INC. AND SUBSIDIARIES Statements of Earnings For the Years Ended December 31, 1997 and 1996 ($ millions)
Percent 1997 of Sales Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost of sales. . . . . . . . . . . . . . . . . . . . . . . . . . .
$10,831 100.0% 8,826 81.5
1996
Percent of Sales
$9,857 8,376
100.0% 85.0
Gross profit. . . . . . . . . . . . . . . . . . . . . . . . . . . . Administrative and selling expenses . . . . . . . . Research and development expenses . . . . . . . Purchased in-process research and development Interest expense. . . . . . . . . . . . . . . . . . . . . . . . Other expenses (income) net . . . . . . . . . . . . . .
2,005 684 461 548 75 (3)
18.5% 6.3 4.2 5.1 0.7 —
1,481 613 412 — 84 70
15.0% 6.2 4.2 — 0.9 0.7
Total expenses . . . . . . . . . . . . . . . . . . . . . . . . .
1,765
16.3%
1,179
12.0%
Earnings (loss) from continuing operations before taxes Excluding purchased R&D; special charges (‘96) Reported earnings (loss) before income taxes Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . .
788 240 289
7.3 2.2 2.7
687 302 120
7.0 3.1 1.2
Earnings (loss) from continuing operations Excluding purchased R&D; special charges (‘96) Reported earnings (loss) after income taxes Discontinued operations, gain on disposition, after tax
499 (49) —
4.6 (0.5) —
434 182 298
4.4 1.8 3.0
Net earnings (loss) . . . . . . . . . . . . . . . . . . . . . . Preference dividends . . . . . . . . . . . . . . . . . . . .
$
(49) —
(0.5)% $ 480 — 1
4.8% —
Earnings (loss) applicable to common stock . .
$
(49)
(0.5)% $ 479
4.8%
Per share of common stock: Average number of shares outstanding (millions) Diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Basic. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted net earnings (loss) per share From continuing operations Excluding purchased R&D; special charges Reported. . . . . . . . . . . . . . . . . . . . . . . . . . From discontinued operations . . . . . . . . . . .
123.7 123.7
132.8 128.7
$4.03 (0.40) —
$ 3.27 1.37 2.25
$ (0.40)
$ 3.62
$4.03 (0.40) —
$ 3.29 1.41 2.31
Basic net earnings (loss) per share . . . . . . . . .
$ (0.40)
$ 3.72
Cash dividends paid . . . . . . . . . . . . . . . . . . . . . Book value per share (year-end) . . . . . . . . . . . Tangible book value per share (year-end) . . . . Other data ($ millions): Depreciation of property, plant, and equipment Amortization of intangibles, other assets . . . . . Capital expenditures. . . . . . . . . . . . . . . . . . . . . Dividends paid . . . . . . . . . . . . . . . . . . . . . . . . .
1.24 13.19 6.58
1.135 17.29 15.62
480 10 549 154
$ 442 10 500 148
Diluted net earnings (loss) per share Basic net earnings (loss) per share From continuing operations Excluding purchased R&D; special charges Reported. . . . . . . . . . . . . . . . . . . . . . . . . . From discontinued operations . . . . . . . . . . .
Source: Adapted from 1997 TRW Inc. annual report.
$
hel78340_ch04.qxd
9/27/01
11:07 AM
Page 101
CHAPTER 4 Assessment of Business Performance
101
are normally related to sales, that is, gross sales revenues adjusted for any returns and allowances. The common base of sales permits a ready comparison of the key costs and expenses from period to period, over longer stretches of time, and against competitor and industry databases. Expense-to-sales ratios are used both to judge the relative magnitude of selected key elements and to determine any trends toward improving or declining performance. However, we must keep in mind the type of industry involved and its particular characteristics, as well as the individual trends and special conditions of the company being studied. For example, the gross margin of a jewelry store with slow turnover of merchandise and high markups will be far greater (50 percent is not uncommon) than that of a supermarket, which depends on low margins and high volume for its success (gross margins of 10 to 15 percent are typical). In fact, comparing a particular company’s ratios to those of similar companies in its industry over a number of time periods will usually provide the best clues as to whether the company’s performance is improving or declining. Many published annual overviews of company and industry performance use ranking approaches, such as the annual Fortune 500 listings. Individual companies usually develop their own comparisons with the performance of comparable units within the organization or with relevant competitors on the outside. It’s also often useful to graphically depict a series of performance data over time, a process now easily achieved with the ubiquitous availability of computer spreadsheets and online financial databases and services.
Gross-Margin and Cost-of-Goods-Sold Analysis One of the most common ratios in operational analysis is the calculation of cost of goods sold (cost of sales) as a percentage of sales. This ratio indicates the magnitude of the cost of goods purchased or manufactured, or the cost of services provided, in relation to the gross margin (gross profit) left over for operating expenses and profit. The ratios calculated from our TRW sample statements appear as follows: $8,826 81.5% (1996: 85.0%) $10,831 $2,005 Gross margin 18.5% (1994: 15.0%) $10,831
Cost of goods sold
The cost of goods sold (81.5 percent) and the gross margin (18.5 percent) indicate the margin of “raw profit” from operations. Remember that gross margin reflects the relationship of prices, volume, and costs. A change in gross margin can result from a combination of changes in: • The selling price of the product. • The level of manufacturing costs for the product. • Any variations in the product mix of the business.
hel78340_ch04.qxd
102
9/27/01
11:07 AM
Page 102
Financial Analysis: Tools and Techniques
In a trading or service organization, gross margin can be affected by a combination of changes in: • • • •
The price charged for the products or services provided. The price paid for merchandise purchased on the outside. The cost of services from internal or external sources. Any variation in the product/service mix of the business.
The volume of operations also can have a significant effect if, for example, a manufacturing company has high fixed costs (see Chapter 6 for a discussion of operating leverage), or a small trading company has less buying power and economies of scale than a large competitor. In the case of TRW, the cost of goods sold and the gross margin shown in the annual report represented a consolidation of the two major business segments. In other words, the income statement combined the automotive business and space, defense, and information systems. We note a gross margin improvement of three and one-half percentage points from the prior year, which was in part affected by the restructuring and acquisition activities during the two years. For a more detailed insight, we should calculate the gross margins for the individual business areas, if this information was publicly available. In its annual report, TRW provided a selective breakdown, by major product line, of sales, operating profit, identifiable assets, depreciation and amortization, and capital expenditures, which would allow the analyst to make some overall comparisons (see p. 157, “Industry Segments”). These data would have to be supplemented by additional internal information, however, to be able to perform a detailed ratio analysis—something routinely done within the company. There are particular complications in the analysis of manufacturing companies. The nature of manufacturing cost accounting systems governs the specific costing of products for inventory and for current sale. Significant differences can exist in the apparent cost performance of companies when using standard full cost systems (all costs, fixed and variable, are allocated to each unit of production based on an estimate of normal cost levels) as compared to using direct costing (fixed manufacturing costs are not allocated to individual products but charged as a block against operations). The charges against a particular period of operations can be affected to some degree by the choice of accounting methods. Increasingly, however, companies are turning to various forms of activity-based accounting for internal purposes, which provides a more precise basis for judging the real economic costs of products and services. Inflation, which affects the prices of both cost inputs and goods or services sold, or currency fluctuations, in the case of international businesses, further distort the picture. We’ll take up some of these issues later in this chapter. Any major change in
